LOS l: Describe the exchange rate risk an investor faces when a bond makes payments in a foreign currency.

Q1. Which of the following statements concerning the exchange rate risk of investing in foreign bonds is most accurate? If the foreign currency:

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

B)   appreciates, the bond's coupon increases.

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

Q2. 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.

Q3. Assume there are two investors: a U.S. citizen and a Swiss citizen. The United States is considered the domestic country and Switzerland is the foreign country. In the context of bond investments, appreciation in the Swiss Franc (CHF) benefits the:

A)   U.S. investor buying Swiss bonds.

B)   U.S. investor buying U.S. bonds.

C)   Swiss investor buying U.S. bonds.

Q4. 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%.

Q5. 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 appreciation in relation to the dollar.

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

C)   omitted the impact of inflation.

Q6. Which of the following statements is FALSE?

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.

LOS l: Describe the exchange rate risk an investor faces when a bond makes payments in a foreign currency.fficeffice" />

Q1. Which of the following statements concerning the exchange rate risk of investing in foreign bonds is most accurate? If the foreign currency:

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

B)   appreciates, the bond's coupon increases.

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

Correct answer is A)        

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.

Q2. 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.

Correct answer is B)

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.

Q3. Assume there are two investors: a ffice:smarttags" />U.S. citizen and a Swiss citizen. The United States is considered the domestic country and Switzerland is the foreign country. In the context of bond investments, appreciation in the Swiss Franc (CHF) benefits the:

A)   U.S. investor buying Swiss bonds.

B)   U.S. investor buying U.S. bonds.

C)   Swiss investor buying U.S. bonds.

Correct answer is A)

The appreciation of the foreign currency (Swiss Franc-CHF) benefits domestic investors (U.S. citizens) who buy foreign (Swiss) bonds. When the CHF appreciates, each unit of CHF is worth more in that it buys more of the U.S. dollar than before. Here, the U.S. investor gains by buying foreign bonds because the investor realizes not only the return from the bond but also a gain from the foreign currency appreciation

Q4. 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%.

Correct answer is A)

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. Calculating the total dollar return on a bond is discussed in more detail later in Study Session 18.

Q5. 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 appreciation in relation to the dollar.

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

C)   omitted the impact of inflation.

Correct answer is B)

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.

Q6. Which of the following statements is FALSE?

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.

Correct answer is B)

This statement should read, "The appreciation of foreign currency benefits domestic investors who buy foreign securities." The other choices are true. 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.

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