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Calculation of the US dollar return on the euro-denominated bonds

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An international investment bank oversees a USA investment portfolio with total assets of $25billion. The portfolio has 15% of total assets allocated to foreign investments, which include both International stocks and bonds.
The investment bank has adopted a position that the domestic markets are efficient and, thus, has indexed the domestic portion of the portfolio. Each unique asset class in the domestic portfolio has been benchmarked individually but the bank believes that foreign markets are less efficient and utilizes active managers for this asset class. The foreign allocation is 60% stocks and 40% bonds and the bank has divided the foreign stock portfolio equally among three different investment managers by reviewing their portfolio betas (current betas of these three portfolios are as follows: 1.1, 0.95, and 1.3).
Examine the strategy of international diversification and the application of the international capital asset pricing model (ICAPM);
Evaluate whether to invest the entire foreign bond allocation in euro-denominated bonds or reallocate the money to US bonds over the next year on the assumption that Euro-denominated bonds are paying a 4.5% interest rate versus USD denominated bonds with a 2.9% rate. The 1-year forward exchange rate is $1.5 per euro, whilst the current exchange rate is at $1.4 per euro. Show your calculation of the US dollar return on the euro-denominated bonds.

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ICAPM; CALCULATION OF THE US DOLLAR RETURN ON THE EURO-DENOMINATED BONDS

An international investment bank oversees a USA investment portfolio with total assets of $25billion. The portfolio has 15% of total assets allocated to foreign investments, which include both International stocks and bonds.
The investment bank has adopted a position that the domestic markets are efficient and, thus, has indexed the domestic portion of the portfolio. Each unique asset class in the domestic portfolio has been benchmarked individually but the bank believes that foreign markets are less efficient and utilizes active managers for this asset class. The foreign allocation is 60% stocks and 40% bonds and the bank has ...

Solution Summary

Calculations of the United States dollar return on the euro-denominated bonds are given.

$2.19
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1. If the current exchange rate is US$1 equals .70, how much did you win in US dollars?

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3. Suppose when you cashed in your CD in Ireland a year from now, the exchange rate had changed from US$1 to ? .70 to US$1 to ? .65. How much would your Irish bank account be worth in US dollars at that point? Would you have been better off leaving your winnings in Ireland or bringing them home to the USA?

4. Explain how banks and individuals can use "covered interest arbitrage" to protect themselves when they make international financial investments.

5. Using the theory of purchasing power parity, explain how inflation impacts exchange rates. Based on the theory of purchasing power parity, what can we infer about the difference in inflation between Ireland and the USA during the year your lottery winnings were invested?

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