Question

Table 2

Scenario	Current interest rate — U.S.	Current interest rate - Japan	Current exchange rate	Expected exchange rate in 1 year
A	2%	4%	¥100 = $1	¥103 = $1
B	3%	6%	¥100 = $1	¥102 = $1
C	5%	2%	¥100 = $1	¥97 = $1
D	4%	7%	¥100 = $1	¥106 = $1

Suppose that you intend to invest $10,000 in one-year government bonds. You are looking for the highest return on your investment and do not care whether you invest in the United States or Japan, but as U.S. resident, you want your investment return to be in U.S. dollars. The Table lists 4 scenarios, each showing the current interest rate for one-year government bonds in the United States and Japan, the current exchange rate between the dollar and the yen, and the expected exchange rate in one year. Other than the interest rates, you assume the bonds from each country to be identical.

Refer to Table 2. With which scenario will you be worst off by investing in Japanese bonds instead of U.S. bonds?

	A.	B
	B.	D
	C.	C
	D.	A

Answer 1

If 10,000 dollar invested in US instead of japan, then return after 1 year in 4 scenarios will be-

Scenario A= 10000(.02) = $ 200

Scenario B = 10000(.03) = $ 300

Scenario C = 10000(.05) = $ 500

Scenario D = 10000(.04) = $ 400

If invested 10,000 dollar in japan now. As current exchange $1 = 100 yen, implies

10,000 $ = (100) x (10000)=1,000,000 yen

Thus, if invested now in japan then return will be in 1 year from now-

Scenario A= 1,000,000(.04) = 40,000 yen

Scenario B = 1,000,000(.06) = 60,000 yen

Scenario C = 1,000,000(.02) = 20,000 yen

Scenario D = 1,000,000(.07) = 70,000 yen

Now, different expectation of exchange rate. In order to determine worst scenario need to compare the return of bond of US & Japan need to compare in same currency. Thus, need to convert either yen return in dollar or US dollar in yen using expected exchange rate. Here, converting US bond return into yen -

Scenario A

Expected Exchange Rate- 103 yen = 1$

So, US return in terms of Yen will be -

200$ = 200 x 103 = 20,600 yen

Scenario B

Expected Exchange Rate- 102 yen = 1$

So, US return in terms of Yen will be -

300$ = 300 x 102 = 30,600 yen

Scenario C

Expected Exchange Rate- 97yen = 1$

So, US return in terms of Yen will be -

500$ = 500 x 97 = 48,500yen

Scenario D

Expected Exchange Rate- 106yen = 1$

So, US return in terms of Yen will be -

400$ = 400x 97 = 42,400 yen

The table showing US & Japan bond return in one year from now (in terms of yen)

Scenarios US Bond return(in yen) Japan Bond return(in yen) US return - Japan return (in yen)

A 20,600 yen 40,000 yen -19,400

B 30,600 yen 60,000 yen -29,400

C 48,500 yen 20,000 yen 28,500

D 42,400 yen 70,000 yen -27,600

Thus, can conclude that C is best scenario to invest in US bond as paying return more than Japan bond (as difference b/w US yen return & Japan yen return is positive, means japan yen return is less than US yen return).

Therefore, scenario C is worst scenario to invest in Japan bond