If you are like most people, you do not own assets in another country. You may own multiple assets—a savings account that pays you some interest every month, perhaps a certificate of deposit, or shares of some company—but the chances are that all your financial assets are denominated in a single currency. In fact, there is no reason why you should not own assets denominated in other currencies, such as euros, or pesos, or British pounds. You might consider opening a bank account in another country. Or you might even consider other financial investments in another country, such as purchasing a share in an international mutual fund, buying shares of a foreign company, or buying the debt of a foreign government.
Most of us do not know exactly how to go about making such investments. In fact, they are easy to carry out if you make use of the services of professional financial advisers. In any case, we are not really interested in the mechanics of foreign investment here. We want to answer a more fundamental question: how do you know if buying foreign assets would be a good idea? Consider the choice between two investment strategies.
- Investing in the United States Deposit $100 in a US bank. Wait for a year.
- Investing in Europe Take $100 and use it to buy euros. Deposit the euros in a European bank. Wait for a year. Withdraw the deposit and interest and use it to buy dollars.
To decide which is the better strategy, you need to determine how much you will earn in each case.
It is straightforward to determine how much you will get with the first option: you will get your $100 plus the interest payments. For example, if the interest rate at the US bank is 10 percent, then after a year you will earn $10 interest for a total of $110.
What about the second strategy? How many dollars will you have if you deposit money in the European bank? This is a bit more complicated. First, you buy euros with your $100. Second, you deposit these euros in a European bank and earn interest. Third, at the end of the year, you withdraw your euros from the bank and sell them for dollars. For example, suppose that the current dollar price of euros is $1.25 and the interest rate paid on deposits in Europe is 5 percent. Suppose you also expect that the price of a dollar in euros will be EUR 0.70 in a year’s time. With the second investment strategy,
- You take your $100 and buy EUR 80.
- You put these EUR 80 in the European bank for a year, giving you EUR 84 at the end of the year.
- You take these EUR 84 and use them to purchase $120.
The second strategy therefore earns you more than the first strategy. It would be better to invest in Europe compared to the United States. Moreover, a slight variation on this strategy seems like it is a money machine. Consider the following.
- Borrow $100 from a US bank for one year.
- Take the $100 and use it to buy euros.
- Deposit the euros in a European bank.
- Wait for a year.
- Withdraw the deposit and interest and use it to buy dollars.
- Repay the dollar loan plus interest.
Using the same interest rates and exchange rates as previously, this transaction works as follows: you borrow $100, obtain $120 at the end of the year, pay back $110 to the bank, and end up with $10 profit.
To evaluate this arbitrage possibility, you need to know (1) the current dollar price of euros, (2) the annual return on deposits in Europe, and (3) the price of a dollar in euros a year from now. Look carefully at the language we used. You need to know “the euro price of dollars a year from now.” But when we went through the example, we said “you expect that the price of dollar in euros will be EUR 0.70 in a year’s time.” As with the term structure of interest rates, there is some risk involved here. You cannot know the future exchange rate with certainty. This strategy entails a gamble about the future exchange rate. Still, if everyone has the same guess about the future exchange rate as you do, then such a situation could not last. Everyone would pursue the same strategy: borrow in the United States, buy euros, invest in Europe, and convert back in a year’s time. What would happen?
- The demand for credit would increase interest rates in the United States.
- The demand for euros would increase the dollar price of euros.
- The extra supply of savings in Europe would drive down the interest rate in Europe.
- Investors might anticipate the extra demand for dollars in a year’s time and expect the euro price of dollars to increase.
These forces would all tend to eliminate the profit opportunity.
So when do we expect this arbitrage opportunity to disappear? It disappears when investors expect to make the same profit whether they invest in Europe or the United States. The condition for this is as follows:
The left side is the return on investing in the United States. The terms on the right give the return on investing in Europe. When this condition holds, the returns on deposits in US and European banks are the same. This condition is called uncovered interest parity.
Because we do not know the price of euros next year for sure, this equation does not hold exactly when we look at actual data from the past. That is, the actual exchange rates combined with the actual returns on deposits do not quite satisfy this equation. This does not contradict the theory. Hindsight is perfect. The important point is that if people hold similar beliefs, then uncovered interest parity will hold ahead of time.
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