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.
Bump: Please reply guys…
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
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…
instead of doing 3 + 2 if you did (1.03)(1.02) you get 1.0506… exactly same answer remember they are doing an approximation as in (1+rf) ( 1+s) -1 = 1+rf + s + rf.s - 1 = rf +S + rf.s now they say rf.s is multiplication of two small numbers - so approx. (1+rf)(1+s) = Rf + s
this is simplified calculation that you use, this should be enough for exam, I would use this too (depending on the given answers)