Assume the expected inflation rate in Finland is 2 percent while it is 4 percent in the U.S.Also assume a risk-free asset in the U.S.is yielding 4.5 percent.What nominal rate of return should you expect on a risk-free Finnish security?

Question

Quizplus · Accepted Answer

Based on the information given, we can calculate the real rate of return for the U.S. risk-free asset as follows:
Real rate of return in the U.S. = Nominal rate of return in the U.S. - Expected inflation rate in the U.S.
Real rate of return in the U.S. = 4.5% - 4% = 0.5%

Since the expected inflation rate in Finland is lower than in the U.S., the nominal rate of return on a risk-free Finnish security should also be lower than the nominal rate of return on a U.S. risk-free asset. We can use the real rate of return in the U.S. and the expected inflation rate in Finland to calculate the nominal rate of return on a risk-free Finnish security:

Nominal rate of return in Finland = Real rate of return in the U.S. + Expected inflation rate in Finland
Nominal rate of return in Finland = 0.5% + 2% = 2.5%

Therefore, the best choice is D) 2.5 percent.

Assume the Expected Inflation Rate in Finland Is 2 Percent