The fixed-income assets include US$10 million invested in one-year US Treasury bonds. Stuyvesant’s evaluation of global bond and currency markets indicates that she can increase the yield on the portfolio by selling the Treasury bond position and buying Japanese government bonds of the same maturity. The data she uses for her assessment show that the US bonds pay 1.75% and Japanese bonds pay –0.40% annualized. She plans to fully hedge the currency risk. The YEN/USD spot rate is 106.85, the one-year YEN/USD forward rate is 106.12, and the one-year YEN/USD cross currency swap basis is –0.63.
Does Stuyvesant’s proposal to buy Japanese bonds most likely increase the yield on the portfolio?
- Yes, it increases the yield.
- No, because the yen appreciation does not compensate for the lower Japanese rate.
- No, because paying the basis would further erode the return on the Japanese government bonds.
Solution
A is correct. Stuyvesant can sell US$10,000 converted at a spot rate of 106.85 to invest proceeds of ¥1,068,500 at –0.40%. After one year, the Japanese bonds are sold (1,068,500 × 0.9960 = 1,064,226.00) and converted at the forward rate of 104.15, for proceeds of US$10,218.20. The fund has earned 10,218.20/10,000 – 1 = 2.18%. The 2.18% yield is higher than the 1.75% she could have earned in US Treasury bills. The difference is due to the basis given a high demand for US dollars.
