The current spot rate for the Norwegian krone is $1 = 6.5483NKR. The expected inflation rate in Norway is 1 % and in Canada 3.8 %. A risk-free asset in Canada is yielding 4.5 %. What risk-free rate of return should you expect on a Norwegian security?

Question

Quizplus · Accepted Answer

The expected risk-free rate of return on a Norwegian security can be calculated using the International Fisher Effect (IFE), which suggests that the expected difference in the nominal interest rates between two countries is approximately equal to their expected inflation rate differential. Given the expected inflation rate in Norway is 1% and in Canada is 3.8%, the expected inflation differential is -2.8% (1% - 3.8%). Since a risk-free asset in Canada is yielding 4.5%, to maintain purchasing power parity, the expected yield in Norway should be approximately 4.5% - 2.8% = 1.7%.

The Current Spot Rate for the Norwegian Krone Is $1