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1. If the Grexit would lead to a higher inflation in the EU zone, what is the impact on the differential of exchange rate between the U.S. and the Euro zone? Then, what is the impact on the bond and the stock market returns and volatility?
That said, let’s mention also that according to the uncovered interest-rate parity (UIP) condition, the expected return on an uncovered domestic-currency investment should equal the expected return on a comparable foreign currency investment. In other words, the expected change in exchange rate = domestic foreign interest rate differential.
Finally, based on the portfolio balance model the current account of the balance of payments, CA, expressed in foreign currency, is: CA =T (S / P) +i *B *. Where the trade balance (T) is a function of competitiveness and it improves if the exchange rate rises or the domestic price level falls. I* B*: nets service receipts.
In order to simplify your analysis, you may focus only on the PPP and UIP to discuss the impacts on potential returns in the bond market and the stock market.
2. “the big risk in the carry trade is the fluctuations in exchange rates, which have a significant effect on the returns on investments (Liu & Yang, 2017).” Considering the exchange rate risk , what strategy can you use to mitigate this risk, hedging or diversification? Why?
*Please answer question 1 and 2 separately
*At least 3 academic/financial references for each: APA format