Caveat Lector: I am not yet in those sections of the material. I see deposit rates in which the pound sterling pays 5% per year, with the U.S. dollar deposits paying only 1.5% (not exact numbers but very much accurate). So, if I change $100k into pound sterling, then deposit and get 5% in a year, wouldn’t that be sensible. Sure, I will be subject to exchange rate risk when the deposit matures, and I will pay a small fee for exchange rate fees, but is this (in general) a good idea?
Yes. This is what we call the carry trade.
But if it works, why doesn’t the interest rate differential disappear? Are you saying this is a risk-free transaction? It is not. Isn’t the exchange rate risk present with all other currencies? Then why the big difference in interest rates with respect to the pound sterling?
This is the basis for interest rate parity. Using direct quotes: Forward Rate / Spot rate = (1 + risk free Domestic Rate) / (1 + risk free Foreign rate). Any difference between the interest rates is reflected in the forward and spot exchange rates. Arbitrage keeps this relationship in place.
But interest rate parity, in what I’ve been able to determine, is merely theory whereas in reality traders/speculators willingly take on the future exchange rate risk in order to earn that interest rate differential. And if you’re really interested in seeing which rates will earn you the best carry, you can push your money in to another G7 currency like the Aussie for 7+% against the Yen at about 1% or if you’re willing to take on some emerging market risk, you can plow your money in to Turkish at somewhere between 18-20% (at least that’s where it was last I checked).
Interest rate parity locks the price of forward contracts through arbitrage relationships, but not necessarily the exchange rate itself. If interest rated were the only thing driving exchange rates, then it should reasonably predict future exchange rates, but they don’t really do such a great job of it. Arbitrage relationships are possible with forward rates because it is possible to set all the transactions at time=0 so that any exchange rate changes down the line don’t really affect anything.
Dreary Wrote: ------------------------------------------------------- > But if it works, why doesn’t the interest rate > differential disappear? It doesn’t because currencies are not traded as discounted assets. Buying more USD does not decrease its yield. You will still get e(rt) more USD after time t, regardless of the price at which you buy USD. Therefore the yield differential does not disappear in equilibrium. The real difference between two currencies comes from inflation, and ability of the sovereign entity to repay debt without monetizing it. In other words, the carry trade is really a good deal if (and only if) the currency preserves its purchasing power over time. In order for that to happen, the higher interest rates must be supported by stronger real (not nominal) gdp growth. A naive view is that if it’s not, the debt size will eventually go beyond the government’s ability to repay it, and it will be tempted to monetize it or even default on it, depending on if it has control over the monetary policy or not. That’s why developed countries usually enforce independence between the monetary authorities and the government. > Are you saying this is a risk-free transaction? > It is not. Of course it is not. Does not mean that it is not a good deal, economically speaking, though. Borrowing money in a zero growth, low interest rate country and investing it in a high growth, high interest rate country is obviously a good deal for everyone. > > Isn’t the exchange rate risk present with all > other currencies? Then why the big difference in > interest rates with respect to the pound sterling?
Cosine with a pretty erudite answer. Well done.
Good points, thanks to all. I’ll have more to say when I get to that section.