Suppose the current spot rate for the Norwegian krone is NKr5.5923 while the expected inflation rate in Norway is 2.2 percent compared to 1.8 percent in the U.S. A risk-free asset in the U.S. is yielding 3.4 percent. What approximate real rate of return should you expect on a risk-free Norwegian security?

Question

Quizplus · Accepted Answer

The formula for calculating the real rate of return is:

[(1 + nominal rate)/(1 + inflation rate)] - 1

Using the given values:

- Nominal rate in the US = 3.4%
- Inflation rate in the US = 1.8%
- Inflation rate in Norway = 2.2%
- Spot rate for Norwegian krone = NKr5.5923

The nominal rate in Norway can be solved as follows:

(1 + nominal rate) = (1 + 3.4%) x (1 + 2.2% - 1.8%)
                    = 1.034 x 1.004
                    = 1.0381

Nominal rate in Norway = 3.81%

To calculate the real rate of return, we use the formula again:

Real rate = [(1 + 3.81%)/(1 + 2.2%)] - 1

Real rate = 1.0156 - 1

Real rate = 1.56%

Therefore, the approximate real rate of return for a risk-free Norwegian security is 1.6%, which is option B.

Suppose the Current Spot Rate for the Norwegian Krone Is