Suppose the one-year nominal interest rate is 2.0% in the United States and 5.0% in Canada. Should you hold Canadian bonds or U.S. bonds? Explain
What will be an ideal response?
It depends whether you expect the Canadian dollars to depreciate relative to the dollar over the coming year by more or less than the difference between the U.S. interest rate and the Canada interest rate, or 3.0% in this case (5.0% - 2.0%). If you expect the Canadian dollars to depreciate by more than 3.0%, then, despite the fact that the interest rate is higher in Canada than in the United States, investing in Canadian bonds is less attractive than investing in U.S. bonds. By holding Canadian bonds, you will get higher interest payments next year, but the Canadian dollars will be worth less in terms of dollars next year, making investing in Canada bonds less attractive than investing in U.S. bonds. If you expect the Canadian dollars to depreciate by less than 3.0% or even to appreciate, then the reverse holds, and Canadian bonds are more attractive than U.S. bonds.
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