Question

IBM (US) needs to raise $100 or an equivalent in foreign currency to fund its operations in New York. It can issue a 3-year maturity Japanese yen bond at par, coupon rate 1% per annum. The current exchange rate is ¥85/$. Alternatively, it can issue the 3-year Eurodollar bond at par, with 3% coupon per year.

You forecast the future exchange rates as follows:
Year 1 - ¥92
Year 2 - ¥98
Year 3 - ¥107

The Bank has quoted the following forward rates for the yen/$ exchange rate:
Year 1 - ¥82
Year 2 - ¥80
Year 3 - ¥77

Assume that the market interest rates are 1% (Japan) and 3% (US) flat for the next three years. Which bond is cheaper for IBN to issue? Covered Bond or Uncovered Bond? Why? Show All Calculations.

Answer 1

Japanese yen bond (Covered)
	Present	Year 1	Year 2	Year 3
Bond in $	100
Exchange Rate( as per forward rate)	85	82	80	77
Bond Value in Yen	8500
Interest (in Yen)		85	85	85
Bond Value(at maturity)		0	0	8500
Total Amount to be paid yearly		85	85	8585
Amount to be paid(in $)		1.04	1.06	111.49
Total Outflow	113.59

Japanese yen bond (Uncovered)
	Present	Year 1	Year 2	Year 3
Bond in $	100
Exchange Rate( as per forward rate)	85	92	98	107
Bond Value in Yen	8500
Interest (in Yen)		85	85	85
Bond Value(at maturity)		0	0	8500
Total Amount to be paid yearly		85	85	8585
Amount to be paid(in $)		0.92	0.87	80.23
Total Outflow	82.02

Eurodollar bond
	Present	Year 1	Year 2	Year 3
Bond in $	100
Interest		3	3	3
Bond Value( at maturity)		0	0	100
Total Amount to be paid yearly		3	3	103
Total Outflow	109.00

From the above 3 tables we can conclude that the Uncovered Japanese Yen bond is the cheapest as its Total outflow(in $) is least.