)Use the data in the tables below to calculate in which country it would have been best to purchase a one-year interest-bearing asset.Consider the following data for interest rates and exchange rates in the United States and Britain:We imagine that the decision is to be made in 2004, looking forward into 2005. How an investor calculates and compares those rates of returns are explored in this chapter.The foreign exchange market (Forex) is not a market like the New York Stock Exchange, where daily trades of stock are conducted in a central location.
One of the prime motivations for investing in another country is because one hopes to make more money on an investment abroad. Thus investors would like to have as high a rate of return on their investments as possible.This means that the rate of return on a domestic interest-bearing account is merely the interest rate.Anyone who has ever traveled to another country has probably had to deal with an exchange rate between two currencies. Thus we plug in the 2005 rate for the expected exchange rate and use the 2004 rate as the current spot rate. In this case, the principal that is originally deposited will grow in value by the percentage exchange rate change. The ER on the forward contract will likely be different from the current spot ER. The exchange rate (ER) will be determined independently by each bank but will essentially be determined by supply and demand in the market. After one year, she must convert pounds back to dollars at the exchange rate that prevails then. On the other hand, if the U.S. dollar strengthens against the foreign currency, it translates each foreign currency unit into fewer U.S. dollars and therefore diminishes your returns.The exchange rate is the price at which the currency of one country can be converted to the currency of another. These investors, be they investment companies, insurance companies, banks, or others, are making currency transactions to realize a greater return on their investments or holdings. represents the number of units of one currency that exchanges for a unit of another. If the importer purchases a sixty-day contract to buy €1,000,000, it will cost him $1,250,000 (i.e., $1,000,000 × 1.25 $/€). Currencies that are traded in large volumes, such as the US $, usually have a narrower spread than currencies that are little used in international dealings. The one plus interest rate term means that the exchange rate return can be separated into two components, a principal component and an interest component.Suppose the exchange rate change is positive. Examples with actual values are presented in a later section.The rate of return on the U.S. CD is simply the interest rate on that deposit. Note also that the interest rate in Japan Before calculating the rate of return, it is necessary to convert the exchange rate to the yen equivalent rather than the dollar equivalent. It highlights some of the more obvious, although sometimes confusing, features and then turns attention to the motivations of foreign investors.
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