An American Hedge Fund is considering a one-year investment in an Italian govern

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.

Using your results to the last question, make a recommendation vis-à-vis when to buy the bond.

Explanation / Answer

The interest rate in euro terms is 5% and US dollar denominated government bonds yield 4%

So if we use the uncovered interest rate parity, currency with lower interest rate appreciates as against currency with higher interest rate. Accordingly, here, Euro depreciates by 1% against USD as euro has higher interest rate and so it will depreciate.

If euro depreciates, the exchange rate shall be 1 Euro = 1.40 $

Which means if we invest 1000 euro today at 1 Euro = 1.50$ , we get 1050 euros back at the end of 1 year at 1 Euro = 1.50 $

Amount invested in $ = 1000*1.50 = $ 1500

Amount received back = 1050*1.40 = $ 1470

We thus incur a loss and therefore it is not advisable to invest if exchange rate after 1 year is expected to be 1 Euro = 1.40 $

However if exchange rate will be 1 euro = 1.80 $ at the end of 1 year,

in that case we make profit on investing (1050*1.80 =1890 ) - (1000*1.50 = 1500) = $ 390

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