The interest rate on one-year risk-free bonds is 2.50 percent in the South Africa and 1.50 percent in France. Treat the ZAR as the domestic currency. The current exchange rate is ZAR0.059 per EUR. Suppose that you are a SA investor, and you expect the Euro to appreciate by 3.50 percent over the next year.

a. Calculate the foreign currency risk premium. (4)

b. Explain why a currency risk premium may be greater than or less than zero. What is the implication of a positive of negative currency risk premium for the return on an investment? (4)

c. There are 2 ways to calculate the return on the foreign bond, assuming that your currency appreciation expectations are met. Prove that both approaches yield the same return for this example. i.e., calculate the return on the investment based on both approaches. (2)

d. A South African investor is considering the purchase of Zambian securities. The current ex- change rate is ZAR1.46000 per Zambian Kwacha (ZMW) Assume that the price level of a typical consumption basket in South Africa is 1.46 times the price level of a typical consumption basket in Zambia. Calculate the real exchange rate. (2)

e. One year later, price levels in SA have risen 2 percent, while price levels in Zambia have risen 4 percent. The new exchange rate is ZAR1.43080 per ZMW. What is the new real exchange rate? (2)

f. Did the South African investor experience a change in the real exchange rate? If so, explain why. If not, explain why not.