1. A zero-coupon British bond promises to pay GBP 100,000 in one year. The current exchange...

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1. A zero-coupon British bond promises to pay GBP 100,000 in oneyear. The current exchange rate is USD 2.00 / GBP and inflation isforecast at 5 percent in the US and 2 percent in the UK. Theappropriate discount rate for a bond of this risk would be 10percent if it paid in USD. What is the appropriate price of thebond today in USD?
2. A US-based manufacturer is considering an internationalinvestment opportunity that will produce the following cash flowsin EUR. The current spot rate is USD 1.50 / EUR. What is the NPV ofthis project in USD if inflation in the US is expected to be 5percent and inflation in Europe is expected to be 10 percent, andthe required rate of return is 10 percent in USD?
Year
CF(EUR)
0
-65,000
1
100,000
2
150,000
Thank you for your help!

Answer & Explanation Solved by verified expert

3.6 Ratings (606 Votes)

1)	Future rate per the Purchasing Power Parity Theory
	= Future spot = Current spot*(1+Inflation rate in US)/(1+Inflation rate in UK)
	= 2*1.05/1.02 =	$ 2.0588
	Amount receivable in $ on realization of the bond in 1 year = 100000*2.0588 =	$ 2,05,880
	Price of the bond today in $ = 205880/1.1 =	$ 1,87,164
2)		0	1	2
	Cash flow in EUR	$ -65,000	$ 1,00,000	$ 1,50,000
	Exchange rate [$/EUR]	1.5000	1.4318	1.3667
	[Future rate per IRPT = 1.5*(1.05/1.10)^n]
	Cash flow in $	$ -97,500	$ 1,43,180	$ 2,05,005
	PVIF at 10% [PVIF = 1/1.1^n]	1.0000	0.90909	0.82645
	PV at 10%	$ -97,500	$ 1,30,164	$ 1,69,426
	NPV of the project in $	$ 2,02,089

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1. A zero-coupon British bond promises to pay GBP 100,000 in oneyear. The current exchange rate is USD 2.00 / GBP and inflation isforecast at 5 percent in the US and 2 percent in the UK. Theappropriate discount rate for a bond of this risk would be 10percent if it paid in USD. What is the appropriate price of thebond today in USD?2. A US-based manufacturer is considering an internationalinvestment opportunity that will produce the following cash flowsin EUR. The current spot rate is USD 1.50 / EUR. What is the NPV ofthis project in USD if inflation in the US is expected to be 5percent and inflation in Europe is expected to be 10 percent, andthe required rate of return is 10 percent in USD?YearCF(EUR)0-65,0001100,0002150,000Thank you for your help!