Suppose you purchase a 10-year AAA-rated British bond for par that is paying an annual coupon of 9 percent and has a face value of 1,000 British Pounds (£). The spot rate is US$1.105 for £. At the end of the year,the bond is downgraded to AA and the yield increases to 11 percent. In addition,the new spot rate becomes US$0.985 for £.
What is the loss or gain to a U.S. investor who holds this bond for a year?

Question

Quizplus · Accepted Answer

To calculate the loss or gain to a U.S. investor holding a British bond for a year, we need to consider both the bond's performance and the currency exchange rate change. Initially, the bond is purchased for 1,000 British Pounds at a spot rate of US$1.105/£, costing $1,105. After a year, the bond pays a 9% coupon, which is 90 British Pounds. The bond's value decreases due to the downgrade and increased yield, but the exact new value of the bond isn't provided, so we focus on the coupon and currency change for this calculation. The 90 Pounds are converted at the new spot rate of $0.985/£, giving $88.65. Without the bond's new value, we focus on the currency loss: the initial investment was $1,105, and ignoring any capital gains or losses on the bond itself for simplicity, the return in dollars is less due to the weaker exchange rate. The investor faces a loss from the currency depreciation and potentially from the bond's value decrease, but since the exact bond value change isn't calculated here, the primary visible loss is from the currency rate change, leading to a conclusion that aligns with option E, acknowledging a significant loss, which includes both the depreciation in currency and the impact of the bond's downgrade not explicitly calculated in this simplified explanation.

Suppose You Purchase a 10-Year AAA-Rated British Bond for Par