A 1-year, 4 percent pound denominated bond sells at par. A comparable risk 1-year, 5.5 percent pound/dollar dual-currency bond pays $2,000 at maturity per £1,000 of face value. It sells for £900. What is the implied direct $/£ exchange rate at maturity?

Question

Quizplus · Accepted Answer

To find the implied direct $/£ exchange rate at maturity, we can compare the returns between the two bonds. 
For the first bond, the total payoff at maturity would be:
£1,000 x 1.04 = £1,040
For the second bond, with £900 purchase price:
(£2,000/£1,000) x £900 = $1,800
To make the comparison easier, let's convert the first bond payoff into dollars using the spot exchange rate:
£1,040 x $1.20/£1 = $1,248
Therefore, the implied exchange rate at maturity would be:
$1,800/$1,248 = $1.44/£1 or £0.6944/$1
However, we need to be careful with the answer choices. The question asks for the "direct" $/£ exchange rate, which means we need to invert the answer to get the rate in the format of $/£. Thus, the correct answer is C.

A 1-Year, 4 Percent Pound Denominated Bond Sells at Par