Question

Kim Smith, 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 11.41%. The bond has a par value of 8,000 Swiss francs (CHF) and is currently trading at 114.08 (i.e., at 114.08% of par).

Kim plans to hold the bond for a period of 1 year, at which time she thinks it will be trading at 120.81-she's anticipating at sharp decline in Swiss interest rates, which explains why she expects bond prices to move up. The current exchange rate is 1.52 CHF/US.$, but she expects that to fall to 1.27 CHF/US$. Use the foreign investment total return formula to find the following information.

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

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? Explain.

Answer 1

a)

Bond's total return = (Ending value - Beginning value + coupon ) / beginning value

Ending value = 120.81

Total ending value = 8000 * 120.81% = 9664.80

Beginning value = 114.08

Total beginning value = 114.08% * 8000= 9126.40

Coupon = 8000/100 * 11.41 = 912.80

Bond's total return = (9664.80 - 9126.40 + 912.80 ) 9126.40

=1450.4 / 9126.40

= 15.89%

b) Investment made in bond in Swiss francs = 9126.40 CHF

Investment made in bonds in USD = Investment in foreign currency / current exchange rate

= 9126.40 / 1.52

= 6004.21 USD

Cashflows recieved after 1 year = coupon + sale of bonds

= 912.80 + 9664.80

= 10577.6 CHF

Cashflows converted in USD = 10577.6 / 1.27

= 8328.82 USD

Retrun on this bond in USD = Ending value / Beginning value - 1

=8328.82 / 6004.21 - 1

= 38.72%

Yes due to the exchange rate difference the return has been enhanced.

Bonds will make good investment as the coupon payments are fixed and it reduces the risk on a diversified portfolio.