Determining Short

Determining Short - 2. appreciation in the value of the DM...

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Determining Short-Run Exchange Rates Interest rates tell us something about short run exchange rates. Suppose you have \$10,000 to invest and you've narrowed your investment options to (1) a U.S. government bond with an 8% interest rate or (2) a German government bond with a 6% interest rate. Which bond is the better investment? It all depends on what you expect to happen to the exchange rate between dollars and German marks. If you invest in the U.S. bond, you will have \$10,800 after one year. If you invest in the German bond you must turn your dollars into marks now and back again in one year. Suppose the exchange rate is now \$1 = DM 2 and that the mark is expected to appreciate 3% over the year so that the exchange rate next year will be \$1 = DM 1.94. \$10,000 today = DM 20,000 DM 20,000 + 6% = DM 21,200 after one year DM 21,200 next year = \$10,928 So, the German bond is the better investment. This is because the German bond provides two sources of return: 1. interest rate
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Unformatted text preview: 2. appreciation in the value of the DM The return on the foreign bond equals the foreign interest rate plus the percentage change in the exchange rate value of the foreign currency. Assets which have identical risk, taxation, and liquidity characteristics ought to have the same return. The U.S. bond and the German bond should have the same return. return on U.S. bond = return on German bond U.S. interest rate = foreign interest rate + percentage change in the exchange rate value of the foreign currency percentage change in the exchange rate = U.S. interest rate - foreign interest rate if the U.S. interest rate is greater than the foreign interest rate, the dollar is expected to depreciate against the foreign currency if the U.S. interest rate is less than the foreign interest rate, the dollar is expected to appreciate the interest rate parity condition may not hold 1. government controls on capital flows 2. political risk 3. differences in tax rates...
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