Reading 70: LOS d ～ Q1- 3

1.A U.K. investor is considering the purchase of a Japanese bond. The current exchange rate is 150 (yen to pounds). The real rate is assumed to be constant. Inflation in Japan is 0 percent and interest rates are 2 percent. U.K. inflation is 3 percent and interest rates are 5 percent. What is the domestic currency return to the purchase of the Japanese bond?

A)   3%.

B)   7%.

C)   2%.

D)   5%.

The correct answer was D)

The domestic currency return on the Japanese bond is equal to the foreign interest rate plus the currency appreciation. Since the inflation differential favors the Japanese bond and the real rate is assumed to be constant, the yen will appreciate by 3 percent. Hence, the domestic currency return is 5 percent (= 2% foreign rate + 3% currency appreciation).

2.A Korean investor (currency = won) is considering the purchase of a U.S. bond. The current exchange rate is 100 (won to $). Korean inflation is 1 percent and U.S. inflation is 5 percent. Interest rates in Korea are 4 percent and in the U.S. are 8 percent. Assuming that the real rate remains constant, what is the domestic currency return from the purchase of the U.S. bond?

A)   4%.

B)   5%.

C)   3%.

D)   12%.

The correct answer was A)

The domestic currency return on the U.S. bond is equal to the foreign interest rate plus the currency appreciation. Since the inflation differential favors Korea and the real rate is assumed to be constant, the dollar will appreciate by –4 percent. Hence, the domestic currency return is 4 percent [= 8% foreign rate + (–4%) currency appreciation].

3.A U.S. investor is considering investing in Swiss bonds. The $/SF (SF = Swiss Franc) exchange rate is 2. Inflation, which is completely predictable, is 5 percent and 3 percent in the U.S. and Switzerland, respectively. Current U.S. interest rates are 7 percent and Swiss interest rates are 5 percent. If the real exchange rate is constant, what is the domestic currency return from buying the Swiss bond?

A)   5%.

B)   3%.

C)   7%.

D)   9%.

The correct answer was C)

The domestic currency return on the Swiss bond is equal to the foreign interest rate plus the currency appreciation. Since the inflation differential favors the SF and the real rate is assumed to be constant, the SF will appreciate by 2 percent. Hence, the domestic currency return is 7 percent (= 5% foreign rate + 2% currency appreciation).