An American Hedge Fund is considering a one-year investment in an Italian govern

Question

An American Hedge Fund is considering a one-year investment in an Italian government bond with a one-year maturity and a euro-denominated rate of return of i€ = 5%. The bond costs €1,000 today and will return €1,050 at the end of one year without risk. The current exchange rate is €1.00 = $1.50. U.S. dollar-denominated government bonds currently have a yield to maturity of 4 percent. Suppose that the European Central Bank is considering either tightening or loosening its monetary policy. It is widely believed that in one year there are only two possibilities: S1 ($|€) = €1.80 per € S1 ($|€) = €1.40 per € Following revaluation, the exchange rate is expected to remain steady for at least another year. Find the ex post IRR in euro for the American firm if they buy the bond today and then the exchange rate falls to S1($|€) = $1.40 per €.

Explanation / Answer

initial invstment = 1000*1.5 = 1500 USD

final value in USD = 1050*1.40 = 1470 USD

IRR = 1470/1500 - 1 = -2.00%

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