LOS f: Calculate the expected (1) exchange rate and (2) domestic-currency holding period return on a foreign bond (security), given expected, predictable inflation rates, the beginning-of-period nominal exchange rate, and the constant real exchange rate.

Q1. 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% and 3% in the U.S. and Switzerland, respectively. Current U.S. interest rates are 7% and Swiss interest rates are 5%. If the real exchange rate is constant, what is the domestic currency return from buying the Swiss bond?

A)   7%.

B)   3%.

C)   5%.

Q2. 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% and U.S. inflation is 5%. Interest rates in Korea are 4% and in the U.S. are 8%. Assuming that the real rate remains constant, what is the domestic currency return from the purchase of the U.S. bond?

A)   3%.

B)   12%.

C)   4%.

Q3. 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% and interest rates are 2%. U.K. inflation is 3% and interest rates are 5%. What is the domestic currency return to the purchase of the Japanese bond?

A)   5%.

B)   3%.

C)   2%.

LOS f: Calculate the expected (1) exchange rate and (2) domestic-currency holding period return on a foreign bond (security), given expected, predictable inflation rates, the beginning-of-period nominal exchange rate, and the constant real exchange rate. fficeffice" />

Q1. A ffice:smarttags" />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% and 3% in the U.S. and Switzerland, respectively. Current U.S. interest rates are 7% and Swiss interest rates are 5%. If the real exchange rate is constant, what is the domestic currency return from buying the Swiss bond?

A)   7%.

B)   3%.

C)   5%.

Correct answer is A)

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%. Hence, the domestic currency return is 7% (= 5% foreign rate + 2% currency appreciation).

Q2. 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% and U.S. inflation is 5%. Interest rates in Korea are 4% and in the U.S. are 8%. Assuming that the real rate remains constant, what is the domestic currency return from the purchase of the U.S. bond?

A)   3%.

B)   12%.

C)   4%.

Correct answer is C)

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%. Hence, the domestic currency return is 4% [= 8% foreign rate + (–4%) currency appreciation].

Q3. 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% and interest rates are 2%. U.K. inflation is 3% and interest rates are 5%. What is the domestic currency return to the purchase of the Japanese bond?

A)   5%.

B)   3%.

C)   2%.

Correct answer is A)        

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%. Hence, the domestic currency return is 5% (= 2% foreign rate + 3% currency appreciation).