Question

Letticia Garcia, an aggressive bond investor, is currently thinking about investing in a foreign (non-dollar-denominated) government bond. In particular, she's looking at a Swiss government bond that matures in 15 years and carries a coupon of 10.88%. The bond has a par value of 9,000 Swiss francs (CHF) and is currently trading at 105.22 (i.e., at 105.22% of par)

Letticia plans to hold the bond for a period of 1 year, at which time she thinks it will be trading at 116.17 -

she's anticipating a sharp decline in Swiss interest rates, which explains why she expects bond prices to move up. The current exchange rate is 1.49 CHF/U.S.$, but she expects that to fall to 1.14

CHF/U.S.$. Use the foreign investment total return formula to find the following information.

a. Ignoring the currency effect, find the bond's total return (in its local currency).

b. Now find the total return on this bond in U.S. dollars. Did currency exchange rates affect the return in any way? Do you think this bond would make a good investment? Explain.

Answer 1

a)

Purchase price of the bond = 9000 * 105.22% = 9469.8

Selling price of the bond = 9000 * 116.17% = 10455.30

Coupon on bond = 9000 * 10.88% = 979.20

Bond's total return in local currency = (Ending value + coupon) / Beginning value - 1

= (10455.30 + 979.20) / 9469.8 - 1

= 20.74%

b)

Purchase price of the bond in USD= 9469.80 /1.49 = $6355.57

Selling price of the bond in USD = 10455.30 / 1.14 = $ 9171.316

Coupon on the bond in USD = 979.20/1.14 = 858.9474

Total return on the bond in USD = (9171.316 + 858.9474 ) / 6255.57 - 1

= 57.82%

The currency effects has increased the returns by 37.05%.

The bond will make good investment.

the foreign bonds has higher yields.

the currency effects can increase the return as we saw in the given case also.

but also these bonds will have a higher risk.