Question

B. Consider the following prices for government bonds and foreign exchange in Canada and the United States. Assume that both governnent securities are one-year bonds, paying the face value of the band one year from now. The exchange rate, El, stands at US81.00 = C$1.33. The face values and prices on the two bonds are given by: Face Value Price Canada C$1000.00 $943.3962 United States US$1000.00 U55961.5384 5. Suppose you buy the bond with the best expected return according to your expected exchange rate of US$1.00 = C$1.30. However, a year later, the actual exchange rate turns out to be US$1.00 = C$1.35. What is your actual return in Canadian dollars? What was your expected return in Canadian dollars? In retrospect, did you make the right decision?

Answer 1

Note:Question has been solved as if bonds were purchased by a person in Canada.If the bond was bought by a person in US answer will change accordingly.

	FACE VALUE	PRICE
CANADA	C$1000	C$943.3962
US	US$1000	US$961.5384

We know current exchange rate,US $1=C $1.33

Current price of US bond in Canadian dollars=1.33×961.5384=C$1278.846

Expected exchange rate US$1=C$1.3

Face value of US bond in C dollars=1.3×1000=C$1300

Therefore return of US bond=((face value-current value)×100)÷current value=((1300-1278.846)×100)/1278.846=1.6541%

Return of the Canadian bond=((1000-943.3962)×100)/943.3962=6%

Therefore Canadian bond has the highest return.

Therefore we will buy the Canadian bond.

Now the actual exchange rate turned out to be US$1=C$1.35.

Since we have chosen the Canadian bond and we need the answer in Canadian dollar being a person from Canada,actual return=expected return

Actual return=expected return=1000-943.3962=C$56.6038=6%

Actual exchange rate,US$1=US$1.35

Actual face value of US bond in C dollars=1.35×1000=$1350

Therefore actual return=(1350-1278.846)×100÷1278.846=5.56%

Therefore actual and expected return of US bond is less than Canadian bond.So in retrospect I made the right decision.

Please note actual return not equal to expected return if bond was bought by a person in US.Since in the question nationality of the person is not mentioned I have taken Canada as default.

Thank you for the question..