Suppose the current spot rate for the Norwegian kroner is $1 = NKr6.6869. The expected inflation rate in Norway is 6 percent and in the U.S. it is 3.1 percent. A risk-free asset in the U.S. is yielding 4 percent. What risk-free rate of return should you expect on a Norwegian security? A.4.5 percent B.4.0 percent C. 6.9 percent D. 5.0 percent E. 3.5 percent

The formula to calculate the expected risk-free rate of return on a foreign security using the Fisher Effect is:

Expected Risk-Free Rate = Nominal Risk-Free Rate + Expected Inflation Rate

Given:

Risk-free rate in the U.S. = 4%

Expected inflation rate in Norway = 6%

Using the Fisher Effect formula, we calculate the expected risk-free rate of return on a Norwegian security:

Expected Risk-Free Rate in Norway= 4% + 6% = 10%

However, this nominal risk-free rate doesn't account for the exchange rate differences between currencies, so to find the risk-free rate in terms of U.S. dollars, we should consider the difference in inflation rates between the U.S. and Norway:

Risk-Free Rate in terms of U.S. Dollars = 

Expected Risk-Free Rate in Norway−Expected Inflation Rate in the U.S.

Risk-Free Rate in terms of U.S. Dollars = 10%−3.1%

Risk-Free Rate in terms of U.S. Dollars = 6.9%

Therefore, the risk-free rate you should expect on a Norwegian security in terms of U.S. dollars is 6.9 percent (option C).