Bond Value Sensitivity to Exchange Rates and Interest Rates Cardinal Company, a U.S.-based insurance company, considers purchasing bonds denominated in Canadian dollars, with a maturity of six years, a par value of C$50 million, and a coupon rate of 12 percent. Cardinal can purchase the bonds at par.
The current exchange rate of the Canadian dollar is $0.80. Cardinal expects that the required return by Canadian investors on these bonds four years from now will be 9 percent. If Cardinal purchases the bonds, it will sell them in the Canadian secondary market four years from now. It forecasts the exchange rates as follows:
| YEAR |
EXCHANGE RATE OF CS |
YEAR |
EXCHANGE RATE OF CS |
|
1
|
$0.80
|
4
|
$0.72
|
|
2
|
0.77
|
5
|
0.68
|
|
3
|
0.74
|
6
|
0.66
|
a. Refer to earlier examples in this chapter to determine the expected U.S. dollar cash flows to Cardinal over the next four years. Determine the present value of a bond.
b. Does Cardinal expect to be favorably or adversely affected by the interest rate risk? Explain.
c. Does Cardinal expect to be favorably or adversely affected by exchange rate risk? Explain.