Question

1. A zero-coupon British bond promises to pay GBP 100,000 in one year. The current exchange rate is USD 2.00 / GBP and inflation is forecast at 5 percent in the US and 2 percent in the UK. The appropriate discount rate for a bond of this risk would be 10 percent if it paid in USD. What is the appropriate price of the bond today in USD?

2. A US-based manufacturer is considering an international investment opportunity that will produce the following cash flows in EUR. The current spot rate is USD 1.50 / EUR. What is the NPV of this project in USD if inflation in the US is expected to be 5 percent and inflation in Europe is expected to be 10 percent, and the required rate of return is 10 percent in USD?

Year	CF(EUR)
0	-65,000
1	100,000
2	150,000

Thank you for your help!

Answer 1

1)	Future rate per the Purchasing Power Parity Theory
	= Future spot = Current spot*(1+Inflation rate in US)/(1+Inflation rate in UK)
	= 2*1.05/1.02 =	$                2.0588
	Amount receivable in $ on realization of the bond in 1 year = 100000*2.0588 =	$ 2,05,880
	Price of the bond today in $ = 205880/1.1 =	$ 1,87,164
2)		0	1	2
	Cash flow in EUR	$              -65,000	$      1,00,000	$     1,50,000
	Exchange rate [$/EUR]	1.5000	1.4318	1.3667
	[Future rate per IRPT = 1.5*(1.05/1.10)^n]
	Cash flow in $	$              -97,500	$      1,43,180	$     2,05,005
	PVIF at 10% [PVIF = 1/1.1^n]	1.0000	0.90909	0.82645
	PV at 10%	$              -97,500	$      1,30,164	$     1,69,426
	NPV of the project in $	$            2,02,089