Finance Basics, part 4

The fourth key point and third implication of market efficiency is to understand the implications of investing in foreign markets. As capital markets become more efficient and barriers to international investing come down, more and more investors look to foreign markets as possible investments. Suppose, for example, one-year U.S. Treasuries are at 5 percent, but the government of Canada is selling one-year Canadian dollar bonds with a 6.0 interest rate, which bonds should the investor buy?

It is tempting to say that obviously 6 percent is better than 5 percent, so buy the Canadian government bonds. The problem is that the payoff of those bonds is in Canadian dollars, and a U.S. investor has to be concerned with the U.S. value of the Canadian dollar in a year’s time. If the Canadian dollar depreciates by 5 percent, the extra 1 percent interest is not worth the 5 percent foreign exchange loss. To remove the possibility of foreign exchange gains and losses, the investor could sell the Canadian dollars at a special exchange rate, called the forward rate, thereby locking in a fixed U.S. dollar return. However, as might be expected, the return from such a strategy, known as covered interest arbitrage, gives essentially the same return as investing in U.S. government securities.

That these covered interest arbitrage strategies in different countries all yield the same return indicates that these forward rates are another set of break-even rates. In this case they are break-even future exchange rates. Just as the term structure of interest rates allows us to estimate where the market expects interest rates to go, in the same way, we can look at a term structure of forward rates as indicative of where the market expects foreign exchange rates to go. Similar to the interest rate forecast, these market foreign exchange rate forecasts are free, except for the cost of a newspaper and the time spent looking in the financial pages: Listen to the market.