FINANCE (Coursework Sample)

Finance Exam Author Institutional Affiliation COURSE####: Course Title Instructor Name Date * Define the risk adjusted Uncovered Interest Rate Parity (UIP) by explaining every term and discuss its economic implications Uncovered Interest Rate Parity (UIP) expounds upon the concept that differences in countries’ interest rates signals trends in their currency foreign exchange rate. This touches on the law of one price, which states that prices of assets eventually become similar in different markets. Therefore, it factors in the risk factor where currencies with high interest rates have a higher chance of depreciating in the future and vice versa (Backus et al., 2013). Therefore, since investors are risk averse, they will demand higher compensation or interest before channeling their resources into perceived risky investments. This short explanation defines Uncovered Interest Rate Parity (UIP). UIP refers to the risk premium investors receive while making investments (Lothian & Wu, 2011). UIP is positive when domestic bonds are riskier than foreign bonds. The UIP is negative in case the domestic bonds are safer than foreign bonds. The implication is that it determines the constitution of investments. The investors will rely on this concept to decide where to channel their resources. Therefore, a positive UIP will encourage investment in foreign bonds whereas a negative UIP will encourage investments in domestic bonds. * Critically evaluate the main type of risks that investors face when investing in a foreign bond (150 words) Investment in a foreign bond exposes the investor to two main types of risks. These include currency risks and country risks. Currency risks emanate from the differences in the denomination currencies of foreign and domestic bonds (Colacito et al., 2018). The risks exist in the conversion rate when recouping or repatriating the investment to the domestic currency. The financial market is not static but keeps fluctuating. Therefore, investors stand to lose a section of their investments whenever negative currency fluctuations occur. On the other hand, country risk country risks emanate from the political and legal factors affecting the particular regime in which the investor chose to invest their resources. In this case, the investor might weigh the risks between foreign and domestic bonds. The specific risk exists in the possibility of a country defaulting on paying its financial obligation to investors. From a different perspective, restrictions imposed on investments from abroad could also cause investors to lose out on their investments. * If the interest rate on US bonds in i=4% and the interest rate on Japanese bonds is i=1%, discuss the expected exchange rate movements, under which a Carry Trade Strategy would be profitable. The carry trade thrives in the tactic whereby investors borrow in low-interest currencies but lend in high-interest currencies. In essence, it all narrows down to maximizing the returns on investments from all transactions in various currencies. In this case, the investors will seek US bonds due to the high interest rates in comparison to the Japanese bonds. Therefore, the US currency will appreciate at the expense of the Japanese yen due to the high demand for US dollars. The exact transaction would occur as follows: an investor borrows Japanese yen and converts it into US dollars before purchasing US bonds. A year later, the investor receives a return on the US bonds, which equa...