3. True/False/Uncertain: Justify your answer with a short argument and if necessary, a graph Suppose interest rates for a one-period deposit are 5% in the Tanzania (the home country) and 2% in Kenya. Assume that the risk premium in Kenya is the same as in the Tanzania. This implies that the investor should invest in Tanzania.
True. The investor should invest in Tanzania because the interest rate is higher in Tanzania compared to Kenya. With a 5% interest rate in Tanzania and only a 2% interest rate in Kenya, it is more profitable for the investor to deposit their funds in Tanzania. This is assuming that the risk premium in both countries is the same, meaning that the additional return provided by the riskiness of investing in Kenya is considered to be equal to the risk premium in Tanzania. Therefore, the higher interest rate in Tanzania makes it the more attractive option for investment.
A graph can also be used to visually represent this situation. The x-axis can represent the countries (Tanzania and Kenya), and the y-axis can represent the interest rates. The graph will show a higher point for Tanzania at 5% and a lower point for Kenya at 2%. This visual representation further supports the argument that investing in Tanzania would yield a higher return for the investor.
False.
To determine whether an investor should invest in Tanzania or Kenya, we need to consider both the interest rate differential and the risk premium differential between the two countries.
Given that the interest rate in Tanzania is 5% and in Kenya is 2%, the interest rate differential is 5% - 2% = 3%. However, we are assuming that the risk premium in Kenya is the same as in Tanzania.
If the risk premium in Kenya is the same as in Tanzania, it means that the additional return investors expect to earn due to taking on the risk in Kenya is the same as in Tanzania. In this case, there is no additional compensation for the higher risk associated with investing in Kenya relative to Tanzania.
If the risk premium is the same in both countries, then the interest rate differential of 3% would imply that the investor should invest in Kenya, as it offers a higher return.
Therefore, the statement is false, and the investor should invest in Kenya based on the interest rate differential, assuming the risk premium is the same in both countries.