Measuring the Inflation Risk in the market

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The “Domestic Fisher Effects” implies that the nominal rate of interest is equal to the sum of real interest rate and the expected inflation rate. K = Re + Onf. Where: K = Nominal Rate of Interest Re = Real Rate of Interest (roughly which is the same across the world) Onf.

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= Inflation Rate The real interest rate is defined as the global economy growth rate, which comes out to be approximately 3%. The nominal interest rate is determined by inflation in a country. That explains why the nominal interest rates differ in two countries. The underlying principle is that investors should be compensated to accommodate for inflation. For example, suppose if you invest in Brazil and you expect to get a 3% real return on your investment and suppose the inflation rate in Brazil is 20%, and then you must get at least 23% nominal rate of return. Otherwise it is really not worth investing.

Foreign Exchange Risk

The Purchasing Power Parity theory implies that the prices of goods, in the nonexistence of restrictions of trade and costs of transportation, should be the same in 2 countries. In short, this leads to the Law of One Price that stands all across the globe. In language of exchange rates, this implies that the exchange rate between two countries should be equal to the ratio of the price level of a fixed basket of goods and services respectively in the two countries. S$/£ = P$/P£ For example, this means that a purse in the US should cost the same as a purse in Canada once you take into account the exchange rate. If the purse cost $5 in the U.S. and let say the exchange rate is 1US$ = 1.50 CAN$, then the purse should cost CAN$7.5 in Canada, otherwise then arbitrage could be possible.

Secondary Risks:-

Political risk associated with investment in foreign country: Nationalization of natural resources (e.g. mines, oil deposits) Limits on repatriation of funds Expropriation Currency controls (e.g. manipulation of exchange rate) Non-tariff barriers design to protect domestic producers (e.g. stringent health or labeling requirements, excessive documentation and ‘red tape’) Country of origin and local content rules, Rules about having local’s nationals form a significant part of senior management. Government or private domestic equity in multinational subsidiary Economic Risk associated with investment in foreign country: Tax regulations and their effect on expected profitability Exchange rate fluctuations Social Risk associated with investment in foreign country: Labor laws Religious differences Cultural differences

Q-2

The portfolio manager wants to fully hedge the primary risks associated with bonds. The primary risk involved is inflation risk and foreign exchange risk. Inflation risk will affect the yield associated with the bonds whereas foreign exchange risk will affect the conversion from foreign currency to UK currency.

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