A zero-coupon British bond promises to pay £100,000 in five years. The current exchange rate is $2.00 = £1.00 and inflation is forecast at 3% in the U.S. and 2% in the U.K. per year for the next five years. The appropriate discount rate for a bond of this risk would be 10% if it paid in dollars. What is the appropriate price of the bond?

Question

Quizplus · Accepted Answer

The bond's future value is £100,000. Discounting it at the UK rate of 10% gives £62,092.13. Converting to dollars at the current exchange rate gives $124,184.26. However, considering the inflation differential, the effective exchange rate in five years would be $2.10 = £1.00, leading to a dollar value of $130,392.26.

A Zero-Coupon British Bond Promises to Pay £100,000 in Five