Final answer:
Calculating the realized rate of return for a US investor in a foreign bond involves not only the bond's yield but also considering the impact of currency exchange rate fluctuations, which can significantly affect the return when the investment is converted back to U.S. dollars.
Step-by-step explanation:
The student is asking about the realized rate of return when a US investor exchanges dollars for euros to purchase a German bond, and then converts the returns back to dollars one year later, considering an exchange rate that has changed. To calculate the realized return in dollars, we must consider both the yield of the bond in euros and the impact of the currency exchange rate between the initial purchase and the conversion back to dollars.
If the US bond was the alternative investment, the comparison requires calculating the return on the German bond in dollar terms and comparing this with the return that would have been achieved with the US bond. Exchange rate fluctuations are pivotal in this comparison because they significantly affect the final return in dollar terms when investing in foreign assets.
For example, let's assume the investor invested in a bond worth 100,000 euros with a fixed return of 5%. At the initial exchange rate, let's say 1 euro equals $1.2, the investment would equate to $120,000. After a year, the bond's return would be 5,000 euros. However, if the exchange rate changes to 0.72 (each euro buys $0.72), upon converting back to dollars, the 5,000 euros would now be worth only $3,600 instead of $6,000 (5,000 euros * $1.2/euro). This shift in the exchange rate negatively impacts the realized rate of return in dollar terms, emphasizing the risks associated with currency exchange rates in international investing.