Ex-post domestic currency return

A U.S. investor purchased a U.K. bond one year ago. The exchange rate at the time was 1.5 to 1 (dollars to pounds) and the beginning-of-period ratio of the price levels of the consumption baskets was 2 ($ to ). Beginning of the year interest rates were 7 percent in the U.S. and 12 percent in the U.K. Inflation during the year was expected to be 5 percent in the U.S. and 10 percent in the U.K. Today the exchange rate is 1.6. What is the ex-post domestic currency return on the U.K. bond to the U.S. investor?

A) 18.67%.

B) 5.33%.

C) 1.64%.

D) 14.67%.

Correct answer: A) 18.67%.

The dollar was expected to appreciate (lower inflation), but depreciated by 6.67 percent (= 1.6/1.5 = 1.0667 or 6.67%) instead. Hence, the return to U.S. investor is the foreign interest rate plus currency appreciation, or 18.67 percent (= 12% foreign rate + 6.67% appreciation).

Ex-post domestic currency return is the return, in term of domestic currency, for holding the foreign investment denominated in foreign currency. Inflation plays no role here. The inflation information is only useful when you calculate the real exchange rate.