Question

Leticia Gareia, an agoressive bond investor, is currenty thinking about investing in a foreign (non-dollardenominated) govemnent bond. In particular, she's iboking at a Saiss government bond that. matures in 15 years and carries a coupon of 10.14%. The bond has a par value of 6.000 Swiss trancs (CHF) and is cumenty trading at 108 a. 4 (ce. at 108.84% of par). Letbola plans to hold the bond for one yea, at which lime she thinks it wal be trading at 114.36- shes andiopating a thurp decline in Swiss interest rates, which euplains whiy she toseces band prices to meve up. The current exchange rate is 1.56 CHFYUS.S, bed she expects tuat to fall to 1.23 CHFAU. S. Use the foreign insestment tocal restam formula to find the folowing infomaton.

a. lgnoring the currency etloct, find the bonds total return (in is local currency).
b. Now find the lotal retum on tils bond in U.S. dollar. Did currency exchange rates atlect the rotum in any way? Do you tink this bend would make a good inrestiment? Explan

Answer 1

To determine the bond's total return in local currency, one must calculate the price appreciation and the coupon payment which results in a 15.08% return. Then, to find the total U.S. dollar return, convert the total CHF return into USD at the beginning and end exchange rates, leading to a 46.16% return. Currency exchange rates significantly impact the return, as seen by the higher USD return due to the anticipated appreciation of the USD against the CHF.

Step-by-step explanation:

To calculate the total return in local currency, we need to consider the bond's price appreciation and the coupon payment. The bond is purchased at 108.84% of its par value and is expected to be sold at 114.36% after one year. Since the par value is CHF 6,000, the purchase price is CHF 6,530.40 (108.84% x CHF 6,000), and the selling price is expected to be CHF 6,861.60 (114.36% x CHF 6,000). The annual coupon payment is 10.14% of the par value, which equals CHF 608.40 (10.14% x CHF 6,000).

To find the local currency return, use the formula: (Selling Price - Purchase Price + Coupon Payment) / Purchase Price. Plugging in the numbers: (CHF 6,861.60 - CHF 6,530.40 + CHF 608.40) / CHF 6,530.40 = 0.1508 or 15.08%.

Next, to calculate the total return in U.S. dollars, consider the initial exchange rate of 1.56 CHF/USD and the anticipated future exchange rate of 1.23 CHF/USD. The total return in CHF is converted into USD by dividing it by the exchange rates at the beginning and end of the period, respectively. The initial investment in USD is CHF 6,530.40 / 1.56 = USD 4,185.51, and the total value after one year in USD is (CHF 6,861.60 + CHF 608.40) / 1.23 = USD 6,118.37. Therefore, the total return in USD is (USD 6,118.37 - USD 4,185.51) / USD 4,185.51 = 0.4616 or 46.16%.

The currency exchange rates have a significant effect on the return, as demonstrated by the higher return in USD compared to CHF. This outcome indicates that the anticipated appreciation of the USD relative to CHF enhances the total return for an investor who converts the proceeds back to USD. Whether this bond makes a good investment or not depends on the investor's risk tolerance, investment strategy, and confidence in the currency exchange rate forecast.