How do I answer this question?
An American Hedge Fund is considering a one-year investment in
an Italian government bond with a one-year maturity and a euro-denominated rate of return of i€ = 5%. The bond costs €1,000 today and will return €1,050 at the end of one year without risk. The current exchange rate is €1.00 = $1.50. U.S. dollar-denominated government bonds currently have a yield to maturity of 4 percent. Suppose that the European Central Bank is considering either tightening or loosening its monetary policy. It is widely believed that in one year there are only two possibilities:
S1 ($/€) = €1.80 per € S1 ($/€) = €1.40 per €
Following revaluation, exchange rate is expected to remain steady for at least another year.
The hedge fund manager notices the optionality in starting this project today. Outline and explain the valuation strategy.
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