Paf is an emerging country with severe foreign investment restrictions but with an active stock market open mostly to local investors. The exchange rate of the pif, the local currency, with the U.S. dollar remains fixed at 1 pif/$. A closed-end country fund, called Pafy Country Fund, has been approved
by Paf. Its net asset value per share is $100. It trades in New York with a premium of 20% at $120. Pafy Country Fund holds a well-diversified portfolio of Paf stocks and you expect the value of the portfolio of Paf stocks held by the closed-end fund to closely track the local stock market index. A few weeks later the Paf stock market has gone up by 10%. Media coverage has attracted attention to the potential of the Paf economy, and the demand of Pafy Country Fund by U.S. investors, especially pension funds, has been increasing; the premium has risen to 30%.
a. What is the new price of the fund listed in New York and the rate of return for an American investor?
b. A few weeks later, Paf suffers from bad press coverage because of poor labor practices, such as employing children. Several pension funds decide to sell their holdings in Pafy Country Fund for ethical considerations. The premium drops to 10%.
c. Should those sales have an influence on the Paf stock market?

Question

Quizplus · Accepted Answer

The Answer is a. The net asset value (NAV) has gone up from $100 to $110 (with a fixed exchange rate). The new fund price in New York should be equal to:
NAV *(1 + Premium) = $110 * (1.30) =$143.
The dollar rate of return on Pafy Country Fund is equal to:

\frac { 143 - 120 } { 120 } = 19.17 \%

which is much higher than the 10% appreciation of Paf stocks.
b. Pafy Country Fund is a closed-end fund. So the selling pressure on Pafy Country Fund cannot lead to sales by the fund of Paf stocks. The drop of the premium should not have a direct influence on the local stock market. It could be, however, that this negative media coverage could hurt the Paf economy by affecting Paf exports and other forms of foreign investments into Paf.

Paf Is an Emerging Country with Severe Foreign Investment Restrictions