Average Yield of Domestic Bonds in Current Portfolio: 3%

Average Yield of Foreign Bonds: 6.2%

Duration of Current Portfolio: 5

Duration of Foreign Bonds: 5

Foreign Country Beta relative to Domestic Country: 0.35

Question: what is the spread widening that would eliminate the foreign bond’s yield adevantage??

answer is (6.2% - 3) / 5 = 64bps change in interest rates

Why isn’t the Country beta used here? shouldn’t it be (6.2% - 3) / (5 * 0.35) ???

You use country beta to see the change in portfolio value when foreign bond yield changes.

The yield advantage is the difference between the two yields, so the change in spread can happen from movements in either end or even movements simultaneously. The difference is an absolute figure if you will and it doesn’t recognize which is foreign which is domestic.

The distance between town A and B is 10 km. It is the same for the inhabitants of both towns.

Yield beta is used in calculation of Change in Foreign bond Value (when domestic rates change), that is,

Change in Foreign bond Value (when domestic rates change) = Duration × yield beta × ∆ Domestic yield × 100

and Duration Contribution of Foreign Bond = wF × DF × Country beta

Portfolio duration = Duration Contribution of Domestic Bond + Duration Contribution of Foreign Bond

In break-even analysis, it is not used. Further, it is important to remember that in break-even spread should be calculated using the higher of the two countries’ durations.

You also need to remember to use the higher of either two bond’s durations for the reasons mentioned above, and adjust the yield according to the question’s timeframe.