Pg 488:PM CFAI expect

bigredhockey55

Example 2: An investor in her home currency wud like to expand her portfolio to include 1 yr bonds in foreign countries. The expected inflation in DC is 3 %, in Fc is 1pc. inflation rates are totally predictable over next year. Exchange rate b/w 2 countries is currently 2 DC units per FC unit. The price level of consumption basket in domestic country relative to foreign country is 2 is to 1. The real exchange rate is 1 to 1. the 1 year interest rate is 5pc flor DC and 3pc for FC. Investor expects real exchange rate to remain constant over time.

Q What are the expected exchange rate & expected return on the foreign bond in domestic currency.

Please help out with second part(expected return on foreign bond)..I am unable to understand the solution provided by CFAI.

Sportsman

Bump: Please reply guys......

busterbluth

you earn 3% on the bond in FC and because DC depreciated, your return in DC is higher due to the depreciation.

you invest 100 DC convert it into FC say at 1:1 and earn 3 %, say 103 FC and you convert it back at new rate 1.02 DC per 1 FC, and you receive 103 x 1.02 = 105.06

thecfawannabe

makes sense what you are saying, but I was attempting it using this
Return = R (FC) + currency return

using this, I got 5 = 3(foreign int rate) + 2(currency movement %)

What is wrong with my approach, since this is the equation that shud be used for calculating return. Please advice....

President1988

this is simplified calculation that you use, this should be enough for exam, I would use this too (depending on the given answers)