Hi 1. In this question regarding differences in yields between 2 bonds, it is mentioned in the revision notes that domestic economy (5% return on bond) would have lower risk free rate than overseas economy ( 2% return on bond). I do not understand why this is so if I follow the required return =rfr+expected inflation +rp 2. I want to understand more deeply on impact of exchange rate on returns. Can you pls explain using some numerical example. Thanks
Hi Komal, The risk free real return is often taken as being the real yield on an index-linked government bond of similar return, which is the rfr in your equation above. The solutions also state that the domestic currency 'may' have a risk free rates - the 'may' is very important here. The lower risk free rate may be as a result of economic stability (so perhaps a stable, low inflation economy?) or cultural issues (perhaps a lower risk free real yield is an accepted return for the savers in that country). These two items could contribute to the rates being different (these are both mentioned in the solutions). I suggest you review Chapter 11, Section 4 for more info on how return can be affected by exchange rates. It is unlikely you will be asked to perform calculations in the context of returns and exchange rates. However, if you do come across another question which specifically goes into this topic and raises further questions, do post here on the forum. All the best Aman ActEd Tutor
Hi Aman Thank you for your reply. In the first part, I undsood the reason for low rfr but I cannot understand why a low rfr in domestic economy is leading to a higher yield on domestic bonds as compared to overseas one, assuming other things are constant? Because total required return is directly related to the rfr.
Unfortunately we can't assume that the other items remain constant. The formula is required return = risk free real yield + expected inflation + risk premium. The yield of 5% in the domestic economy could well be as a result of expected inflation, or a risk premium. The question doesn't enable us to determine why the 5% is 5%. We are unable to make the assumption that the other things remain constant. Does that help? Thanks Aman ActEd Tutor
