Question

Suppose the interest on a foreign government bonds is 7.5%, and the current exchange rate is $0.03571/foreign currency (i.e. 28 foreign currencies per dollar). If the forward exchange rate is $0.03508/foreign currency (i.e. 28.5 foreign currencies per dollar), and the current US risk-free rate is 4.5%, if the effective foreign risk-free rate is 6.366%. Which of the following is most likely to be correct?
A) The foreign government bond is a superior investment than the US Treasury bond.
B) The foreign government bond is less risky than the US Treasury bond.
C) The implied country risk premium of the foreign government bond is positive.
D) The fluctuation of $/foreign currency exchange rate will not affect the risk premium of the foreign government bond.
E) The capital markets between the US and the foreign country must be fully integrated.

Answer 1

Answer: C) The implied country risk premium of the foreign government bond is positive.

Explanation:

Given that the effective foreign risk-free rate is 6.336% and the interest on the foreign Govt. bonds is 7.5%, this would mean that the foreign govt. is offering higher on it's bonds than its risk free rate which means there is a premium.

The premium is;

= 7.5% - 6.366%

= 1.134%

This means that the implied country risk premium of the foreign government bond is positive.