Imagine you are a German investor trying to decide whether to buy American or European bonds. A ten-year bond issued by America’s Treasury today offers about 3%; German bonds return only 1.2%. But buying American means taking a gamble on the euro-dollar exchange rate. You are interested in the return in euros. The bond issued in the US will be attractive only if the extra yield exceeds any expected loss due to swings in currency markets. This thinking explains why the dollar has recently soared against the euro. In July 2022 the dollar reached a one-for-one exchange rate with the euro for the first time since 2002. Is it always true that a currency appreciates in value when the interest rate it offers increases relative to foreign interest rates? Explain.
Imagine you are a German investor trying to decide whether to buy American or European bonds. A ten-year bond issued by America’s Treasury today offers about 3%; German bonds return only 1.2%. But buying American means taking a gamble on the euro-dollar exchange rate. You are interested in the return in euros. The bond issued in the US will be attractive only if the extra yield exceeds any expected loss due to swings in currency markets. This thinking explains why the dollar has recently soared against the euro. In July 2022 the dollar reached a one-for-one exchange rate with the euro for the first time since 2002. Is it always true that a currency appreciates in value when the interest rate it offers increases relative to foreign interest rates? Explain.
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