Suppose that you intend to invest $10,000 in one-year government bonds. You are looking for the highest return on your investment and do not care whether you invest in the United States or Japan, but as a U.S
resident, you want your investment return to be in U.S. dollars. Assume the current interest rate on one-year government bonds is 3% in the United States and 7% in Japan, the current exchange rate is ¥100 = $1, and the expected exchange rate in one year is ¥110 = $1. a. What is your return on Japanese bonds? b. Would you have been better off investing in Japanese bonds or U.S. bonds? Explain. c. For the interest parity condition to hold, what would have to happen to the interest rate on Japanese bonds, assuming all other data remains the same?
a. The return on Japanese bonds = 7% - 10% = -3%.
b. The return on Japanese bonds is -3% and the return on U.S. bonds is +3 percent, so investing in U.S. bonds would be the better choice.
c. The interest rate on Japanese bonds would need to increase by 6% (from 7% to 13%) to make the return on Japanese bonds equal to the 3% return on U.S. bonds.
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