Question

Letticia​ Garcia, an aggressive bond​ investor, is currently thinking about investing in a foreign​ (non-dollar-denominated) government bond. In​ particular, she's looking at a Swiss government bond that matures in 15 years and carries a coupon of  8.62%. The bond has a par value of 9,000 Swiss francs​ (CHF) and is currently trading at 106.22​(i.e., at 106.22​% of​ par).

Letticia plans to hold the bond for a period of 1​ year, at which time she thinks it will be trading at 111.03—​she's anticipating a sharp decline in Swiss interest​ rates, which explains why she expects bond prices to move up. The current exchange rate is 1.55 ​CHF/U.S.$, but she expects that to fall to 1.26 ​CHF/U.S.$. Use the foreign investment total return formula to find the following information.

part a. Ignoring the currency​ effect, find the​ bond's total return​ (in its local​ currency).

part b. Now find the total return on this bond in U.S. dollars. Did currency exchange rates affect the return in any​ way? Do you think this bond would make a good​ investment

A.The better return is in U.S. dollars. Exchange rates yielded a higher total return because the dollar depreciated relative to the Swiss franc. The bond would make a good investment if the​investor's required rate of return is at least equal to the​ bond's total return.

B.The better return is in the local currency. Exchange rates yielded a lower total return because the dollar depreciated relative to the Swiss franc. The bond would make a good investment if the​ investor's required rate of return is at least equal to the​ bond's total return.

C.The better return is in U.S. dollars. Exchange rates yielded a lower total return because the dollar depreciated relative to the Swiss franc. The bond would make a good investment if the​investor's required rate of return is at least equal to the​ bond's total return.

Answer 1

Given,

Face Value= CHF 9,000. Coupon rate= 8.62%

Therefore, interest for one year (I)= CHF 9,000*8.62%= CHF 775.80

Also given, Current price is at 106.22 = CHF 9,000*106.22% (P0)= CHF 9559.80

Expected price in one year at 111.03= CHF 9,000*111.03% (P1) = CHF 9992.70

Part (a):

Total return in local currency= (P1-P0+I)/P0 = (9992.70-9559.80+775.80)/ 9559.80 = 12.643570%

Part (b):

Exchange rate now= 1.55 CHF/US$

Hence investment price (P0) in US$= 9559.80/1.55 = $6167.612903

Exchange rate expected in 1 year= 1.26 CHF/US$

Hence interest in US$= 775.80/1.26= $615.714286

Sale price in US$= 9992.70/1.26 = $7930.71429

Total return in US$= (7930.71429-6167.612903+615.714286)/ 6167.612903 = 38.569471%

Regarding the narrative, option A is selected. Better return is i9 US Dollars. The Exchange rates yielded a higher total return because the dollar depreciated relative to the Swiss franc. The bond would make a good investment if the​investor's required rate of return is at least equal to the​ bond's total return.