Suppose the U.S. one-year interest rate is 3% per year, while a foreign country has a one-year interest rate of 4% per year. Ignoring risk and transaction costs, a U.S. investor should invest in foreign bonds as long as the expected yearly rate of depreciation of the foreign currency isGroup of answer choicesless than 5%.greater than 5%.greater than 2%.less than 1%.
Question
Suppose the U.S. one-year interest rate is 3% per year, while a foreign country has a one-year interest rate of 4% per year. Ignoring risk and transaction costs, a U.S. investor should invest in foreign bonds as long as the expected yearly rate of depreciation of the foreign currency isGroup of answer choicesless than 5%.greater than 5%.greater than 2%.less than 1%.
Solution
The U.S. investor should invest in foreign bonds as long as the expected yearly rate of depreciation of the foreign currency is less than 1%.
Here's why:
The difference in interest rates between the two countries is 1% (4% - 3%). This means that, all else being equal, an investor can earn 1% more by investing in the foreign country. However, if the foreign currency is expected to depreciate by more than this 1% difference, the investor would lose money when they convert the foreign currency back to U.S. dollars.
Therefore, the investor should only invest in the foreign bonds if they expect the foreign currency to depreciate by less than 1% over the year. If the depreciation is expected to be more than 1%, the investor would be better off investing in U.S. bonds.
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