JrHeadcon is hydro-construction firm with a government contract to in JrHeadcon is hydro-construction firm with a govern | Page 2

foreign bonds to
boost his investment returns. He has never invested in foreign bonds
before but is about to buy
100M Lower Slobovian dollars’ (the acronym is LSD) worth of one-
year-maturity Lower
Slobovian treasury bills.
Lower Slobovia has for years been on a fixed exchange rate relative
to the USD at par (that is,
one LSD for one USD.)
Your boss wants to buy the Lower Slobovian treasury bills because
they pay 10% in LSDs while
one-year US Treasuries pay only 2% in USDs. “It’s a risk-free 8%
spread! The fixed exchange
rate policy of the Lower Slobovian government guarantees our profit
by keeping the LSD-USD
exchange rate fixed at par!” your boss exclaims, actually drooling at
the prospect of an easy, riskfree profit.
Afterwards, back in your office, second thoughts about this deal start
to arise as you remember
some important lessons from your International Finance class that
directly apply here. Critique
your bosses belief that he will make an easy profit from the LSD
bonds.
Hint: Use the Augmented International Fisher Equation in Note Set 7
to decompose what factors
(and risks) you (and he) should consider before undertaking this bond
purchase. 3. Explain what the Carry Trade is and how Carry Traders
expect to make money.
Use the UIP equation in log approximation form to explain. Hint: See
discussion in Note Set 6.
4. When are Expected Relative PPP and UIP the same?
Hint: See Exhibit 7.4 in Note Set 7.
5. In developing a forecast for a fixed exchange rate, what two factors
are critical in a
government’s decision to maintain its promise of a fixed exchange
rate?
Hint: See Note Set 9. 6. Why does the Efficient Markets Hypothesis,