explain how including a relative risk premium (1+?) in the interest parity condition (as in p467-8 of the textbook) might resolve the puzzle.

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Question 1 Interest parity Consider two bonds—one issued in Yen in Japan, one issued in Australian dollars in Australia. Assume that both government securities are one-year bonds—paying the face value of the bond one year from now, and have no risk of default. The exchange rate, E, stands at 1A$ = 95 Yen (¥) on 11 May 2015. The face values and prices on the two bonds are given by Face Value Price Australia 1-year bond A$10,000 A$9,615.38 Japan 1-year bond ¥13,333 ¥13319.68 a. Compute the nominal interest rate on each of the bonds. b. Compute the expected exchange rate for next year (11 May 2016) consistent with the interest parity relation. At this expected exchange rate, what is the difference between your expected rate of return in A$ from buying the Japanese bond and what you would have made had you bought the Australian bond? c. If instead, you expect the A$ to appreciate in 1 year relative to the ¥, which bond should you buy? d. Assume you are an Australian investor. You exchange A$ for ¥ and purchase the Japanese bond. One year from now it turns out E is actually 96 (1A$ = ¥96). What is your realized rate of return in A$ compared to the realized rate of return you would have made had you held the Australian bond? e. Are the differences in rates of return in (d.) consistent with the interest parity condition? If not, explain how including a relative risk premium (1+?) in the interest parity condition (as in p467-8 of the textbook) might resolve the puzzle.

 

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