Jim Whitney Economics 311

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$
 
14. Step 3: Convert back to $ at EFWD ESP·(1+ifor)
EFWD
  1.0603 / 1.0467
= $1.0130
 
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
 
23. Annual percentage rate of return on foreign bonds for US savers: 1/4-year earnings 
· 4 · 100
  .0821·4·100
= 32.84%