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Consider the interest rate and exchange rate relationships between two countries, M and B. Suppose that covered interest parity and expected relative PPP both hold

Consider the interest rate and exchange rate relationships between two countries, M and B. Suppose that covered interest parity and expected relative PPP both hold between these countries, and we have the following information:

  • M's annual interest rate is 4%.
  • B's annual interest rate is 3%.
  • M's expected inflation rate over the coming year is 5%.
  • B's expected inflation rate over the coming year is 2%.
  • The price of B's currency is 40 units of M's currency.

What should be the risk premium for holding onto country M assets rather than country B assets? (Please use all numbers presented in the question to find the solution).

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