What is the implied risk premium

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Reference no: EM132198927

Question: Uncovered vs Covered Interest Rate Parity.

In June 2006, a Brazilian investor is considering investing in bank deposits in Brazil and Canada. The annual interest rate on Brazilian deposits is 6.25%, versus 3.75% on deposits in Canada. Suppose that the forward rate in June 2006 is equal to Reales/CAD = 8.2. In June 2006, the expected exchange rate for delivery in Jun 2007 is 8.25 Reales/CAD. For the remainder of this question, please use the linear approximations for uncovered and covered interest rate parity. The spot exchange rate in June 2006 is Reales/CAD=8.

a) Does covered interest parity hold in this example? If so, how do you know?

b) Does uncovered interest parity hold in this example? If so, how do you know? If not, what is the implied risk premium? Which deposits pay a higher expected return?

c) Suppose the exchange rate in June 2007 is equal to 8.528 reales per Canadian dollar. Calculate the Brazilian investors actual return, assuming that he invests in Canadian deposits in June 2006. How do these answers compare with those from (b)?

d )Consider two Brazilian investors: one uses speculation and the other uses hedging. Based on your previous answers, which one earned a higher return (or smaller loss) on Canadian assets between June 2006 and 2007? Explain briey why.

Reference no: EM132198927

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