Friday, April 13, 2012 |
Comparing domestic and foreign returns in practice
1. | Comparing annual rates of return on domestic and foreign 3-month government bonds, mid-July 2007: | ||||
2. | U.S. interest rate: Full year | 4.940% | |||
3. | 1/4 year | 1.235% | |||
4. |
End result (formula) | Britain | Canada | Japan | |
5. | Interest rates (i): Full year | 5.820% | 4.510% | 0.700% | |
6. | 1/4 year | i/4 | 1.1275% | ||
7. | Exchange rates (E) | £/$ | Ca$/US$ | ¥/$ | |
8. | Spot (ESP) | 0.4916 | 1.0485 | 122.01 | |
9. | 3-mo. Forward (EFWD) | 0.4923 | 1.0467 | 120.60 | |
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11. | Covered interest arbitrage: | ||||
12. | Step 1: Convert $1 to FX at ESP | ESP | $1g1.0485 Ca$ | ||
13. | Step 2: Earn foreign interest for 3 months (1/4 year) | ESP·(1+ifor) | Ending Balance = 1.0485*(1.011275) = 1.0603 Ca$ |
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14. | Step 3: Convert back to $ at EFWD | ESP·(1+ifor) EFWD |
1.0603 / 1.0467 = $1.0130 |
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15. | Annual percentage rate of return on foreign bonds for US savers: | 1/4-year earnings · 4 · 100 |
.0130·4·100 = 5.20% |
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17. | Uncovered interest arbitrage: | ||||
18. | Spot exchange rates (ESP) | Pds/$ | Ca$/$ | Yn/$ | |
19. | mid-July 2007 | 0.4916 | 1.0485 | 122.01 | |
20. | mid-October 2007 | 0.4921 | 0.9799 | 116.70 | |
21. | Steps 1 and 2 - same as above | 1.0603 Ca$ | |||
22. | Step 3: Convert back to $ at future ESP | ESP,7/07·(1+ifor) ESP,10/07 |
1.0603 / 0.9799 = $1.0821 |
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23. | Annual percentage rate of return on foreign bonds for US savers: | 1/4-year earnings · 4 · 100 |
.0821·4·100 = 32.84% |