5) The following equation describes the return for an investor who buys a foreign currency at time t and sells it at time t+1: T+1 AS+1 where the log foreign interest rate, it is the log domestic interest rate, and AS++1 is the change in the log exchange rate (higher s implies appreciation of the domestic currency). In normal conditions the following equation also holds: where f, is the forward exchange rate and f-s, is the forward discount. Lustig, Roussanov and Verdelhan (2011) [Review of Financial Studies 24, 3731-3777], form on a monthly basis 6 portfolios of foreign currencies versus the US dollar based on the observed forward discount fi-st (portfolio 6 has the highest forward discount and portfolio 1 the lowest). In the table below, they report the mean excess return, volatility and Sharpe ratio for each of the portfolios. Portfolio 4 Panel I: All Countries Spot change: As Mean Std -0.64 8.15 -0.92 7.37 -0.95 -2.57 -0.60 2.82 7.63 7.50 8.49 9.72 Forward Discount: fi-si Mean -2.97 -1.23 -0.09 Std 0.54 0.48 0.47 1.00 0.52 2.67 9.01 0.64 1.89 Excess Return: rx (without b-a) Mean -2.33 -0.31 0.86 3.57 3.27 6.20 Std SR 8.23 -0.28 7.44 -0.04 7.66 7.59 8.56 9.73 0.11 0.47 0.38 0.64 a) Comment briefly on the performance of these portfolios. Can you explain these results given the data also presented in the table about the mean fi-si and mean As' of each portfolio? (8 marks) b) Which condition is violated here and what would the expected value of these portfolios be if the condition was valid? (7 marks)