jawz

Which of the following statements about currency risk is most accurate? Generally:

A) if the foreign currency appreciates, the foreign cash flow will be worth less for the domestic investor.

B) appreciation of the foreign currency is good for domestic investors who buy foreign securities.

C) if the home currency appreciates against the foreign currency, each foreign currency unit will be worth more in terms of the home currency.

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If the home currency appreciates against the foreign (i.e., payment) currency, each foreign currency unit will be worth less in terms of the home currency. If the foreign currency appreciates, a given foreign cash flow will be worth more units of the home currency, thereby benefiting the domestic investor holding foreign securities.

jawz

Which of the following statements concerning the exchange rate risk of investing in foreign bonds is most accurate? If the foreign currency:

A) appreciates, the bond's coupon increases.

B) depreciates, the bond's coupon payments will turn into more U.S. dollars.

C) depreciates, bond investors lose, all else equal.

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If the foreign currency depreciates, bond investors lose, all else equal. This occurs because the bond’s coupon payments and principal will convert to fewer U.S. dollars.

jawz

Which of the following statements is NOT correct?

A) Exchange-rate risk may benefit a bond investor.

B) The depreciation of foreign currency benefits domestic investors who buy foreign securities.

C) An investor who purchases a foreign bond gains the most when both the asset and the foreign currency appreciate in value.

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This statement should read, "The appreciation of foreign currency benefits domestic investors who buy foreign securities." The other choices are correct. Exchange rate risk creates uncertainty for the investor, but is not always bad for the investor. If a domestic investor purchased a foreign currency denominated bond, appreciation in the foreign currency would benefit the investor.

jawz

While serving as visiting conductor at the University of Edinburgh, U.S. Citizen William Golson purchases a 9.0% annual coupon bond denominated in the local currency for 93.0. One year later, before his return to the U.S., he sells the bond for 99.5. Using a holding period return formula he remembers from his undergraduate studies, he calculates his return at 16.7%. On the flight home, he is seated next to Kristin Meyer, CFA. She is puzzled because she has heard that similar investments yielded negative returns over the same time period. After consulting her financial newspaper, she recalculates Golson’s return at a disappointing negative 5.2%.
Assuming Meyer is correct, which of the following statements is the most likely reason for the difference in the calculated returns? Golson:

A) forgot to include the impact of foreign currency depreciation in relation to the dollar.

B) forgot to include the impact of foreign currency appreciation in relation to the dollar.

C) omitted the impact of inflation.

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Golson most likely forgot to take into account the impact of the percentage change in the dollar value of the foreign currency. Here, since the correct return (calculated by Meyer) is lower than that calculated by Golson (who omitted the impact of foreign exchange), the foreign currency depreciated in relation to the dollar. The appreciation in the bond value was not enough to offset the currency depreciation, and the total return in dollar terms was negative. Calculating the total dollar return on a bond is discussed in more detail later in Study Session 18.

jawz

While working abroad, U.S. citizen Dirk Senik purchases a foreign bond with an annual coupon of 7.5% for 95.5. One year later, the exchange rate between the dollar and the foreign currency remains unchanged and he sells the bond for 97.25, resulting in a holding period return of 9.7%. If the foreign currency had depreciated in relation to the dollar, Senik’s return would be:

A) less than 9.7%.

B) greater than 9.7%.

C) equal to 9.7%.

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The return on a foreign bond is a combination of the return on the bond and the movement in the foreign currency. In the base case, the movement in the foreign security was 0 and thus the return was just the holding period return on the bond. If the foreign currency depreciates, the return will be lowered because the investor will lose upon conversion to the dollar.

burning0spear

Which of the following investors is least susceptible to inflation risk?

A) The holder of a 15-year bond with a coupon formula equal to the U.S. prime rate plus 3.25%.

B) An individual with a 5 year certificate of deposit at a local financial institution.

C) A financial institution with assets concentrated in fixed-rate mortgages.

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A 15-year bond with a coupon formula equal to the U.S. prime rate plus 3.25% is an example of a floating rate bond. The holder of an adjustable rate asset is impacted less by inflation than the holder of a fixed-rate asset because the increased cash flow (from the higher coupon payments when the base rate increases) at least partially offsets the decreased purchasing power caused by inflation.
The other two choices are examples of investors more susceptible to inflation - those who hold long-term contracts in which they are to receive a fixed payment.

burning0spear

Which of the following statements about inflation risk is NOT correct?

A) Treasury securities are considered immune to inflation and liquidity risk.

B) The short term inflation premium is less than the long term premium.

C) The real return on a fixed coupon bond is variable.

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The statement Treasury securities are considered immune to inflation and liquidity risk is partially true – Treasury securities are immune to liquidity risk, but fixed-coupon Treasury securities have high inflation risk and generally low real returns.
The other choices are correct. The inflation premium is less in the short term because investors are better able to predict inflation in the short term – inflation risk increases as time increases. (Investors want to be compensated for this uncertainty.) An investor’s real return is not fixed- even though an investor may hold a fixed-rate coupon bond, the real return depends on a variable – inflation. Higher inflation rates result in a reduction of the purchasing power of bond payments.

burning0spear

One year ago, Makato Omura purchased a 6.50% fixed coupon bond for 98.50. Recently, she sold the bond for 99.25 and calculated her return at 7.4%. Her friend, Takanino Takemiya, CFA, reminds Omura that this is the nominal return and that to calculate the real return, she needs to factor in the inflation rate over the holding period. If the price index for the current year is 118.5 and the price index one year ago was 115.9, Omura’s real return is closest to:

A) 9.6%.

B) 6.3%.

C) 5.2%.

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Omura’s real return is approximated by subtracting the inflation rate from the calculated (nominal) return. The inflation rate is calculated using the formula:Inflation = (Price Indexthis year – Price Indexlast year) / Price Indexlast year
Here, inflation = (118.5 – 115.9) / 115.9 = 0.0224, or approximately 2.2%.
Thus, the real return = 7.4% - 2.2% = 5.2%.

burning0spear

David Korotkin, CFA and a broker at an investment bank, has a client who is very concerned about maintaining purchasing power over the next year. The investor is conservative, and to date has been pleased with a consistent return of 8.00%. The bank’s research department has estimated next year’s inflation rate at 2.0%. The client specifically wants to invest in a fixed-coupon bond. Which of the following statements is most correct? If Korotkin purchases a bond with a 10.00% coupon, the client:

A) will not lose purchasing power.

B) may lose purchasing power.

C) will realize a real gain.

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Investors want to be compensated for the inflation they expect plus for the risk that inflation will increase during the term of the investment. Here, the bank’s estimated inflation rate is just that – an estimate. Thus, we cannot say for certain that the investor will not lose purchasing power. Inflation risk introduces uncertainty to the investment process.

burning0spear

Simone Girard, CFA candidate, is studying yield volatility and the value of callable bonds. She has the following information: a callable bond with a call option value calculated at 1.25 (prices are quoted as a percent of par) and a straight bond similar in all other aspects priced at 98.5. Girard also wants to determine how the bond’s value will change if yield volatility increases. Which of the following choices is closest to what Girard calculates as the value for the callable bond and correctly describes the bond’s price behavior as yield volatility increases?

A) 97.25, price decreases.

B) 97.25, price increases.

C) 99.75, price decreases.

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To calculate the callable bond value, use the following formula:
Value of callable bond = Value of straight bond – Call option value
Value of callable bond = 98.5 – 1.25 = 97.25.
Remember: The call option is subtracted from the bond value because the call option is of value to the issuer, not the holder.
As yield volatility increases, the value of the embedded option increases. The formula above shows that for a callable bond, an increase in the option value results in a decreased bond value.