An American Hedge Fund is considering a one-year investment in an Italian govern
ID: 2618896 • Letter: A
Question
An American Hedge Fund is considering a one-year investment in an Italian government bond with a one-year maturity and a euro-denominated rate of return of i€ = 5%. The bond costs €1,000 today and will return €1,050 at the end of one year without risk. The current exchange rate is €1.00 = $1.50. U.S. dollar-denominated government bonds currently have a yield to maturity of 4 percent. Suppose that the European Central Bank is considering either tightening or loosening its monetary policy. It is widely believed that in one year there are only two possibilities: S1 ($|€) = €1.80 per € S1 ($|€) = €1.40 per € Following revaluation, the exchange rate is expected to remain steady for at least another year. Find the ex post IRR in euro for the American firm if they buy the bond today and then the exchange rate rises to S1($|€) = $1.80 per €.
Explanation / Answer
Let American firm purchase 1 bond in Euro today ,current exchange rate is €1.00 = $1.50
Cost of bond = €1,000 = $ 1000 * 1.5 = $ 1500
After 1 year in invesment in Bond of Euro ,exchange rate €1.00 = $1.80
Value of Bond = €1,050 = 1,050 * $1.80 = $ 1890
At the Same time In American market @ 4% per year ,
Value of intial investment of US$ after 1 year = 1500 * ( 1+4%) = $ 1560
ex post IRR ( actual returns) in euro for the American firm = value of bond in Euro - value in American market
= $ 1890 - $ 1560 = $ 330
% return = $ 330 / $ 1500 = 22%
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