Arnold Kling  

Uncovered Interest Parity

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Brad DeLong wonders,


U.S. interest rates are low relative to those of other major countries (save Japan).

Where is my uncovered interest parity?


Here is what Brad is thinking. If I own dollars today and want to invest in bonds that will pay me in dollars tomorrow, there are two ways that I might do so. (1) Buy U.S. bonds denominated in dollars.; or (2) Buy European bonds denominated in euros and in ten years convert the euros back to dollars.

The choice depends on the combination of the interest differential and the expected change in the exchange rate. For example, if I knew that the exchange rate were going to stay fixed for ten years, then I would simply buy the bonds with the higher interest rate. Conversely, if the interest rates were identical, I would buy the bonds whose currency is most likely to appreciate.

Brad is saying that interest rates on European bonds are higher. So, investors must be expecting the dollar to appreciate (slightly) over the next ten years. Yet Brad believes that the dollar has to fall significantly, and probably soon, to reduce our trade deficit.

I think that the main issue here is that compared with the markets, Brad and other economists believe much more strongly that the trade deficit means that the dollar is over-valued. This difference in beliefs is nothing new. Perhaps the markets know something that economists are overlooking. If the economists are right, then foreign securities are a bargain.

For Discussion. If you believe the economists, but you think it could take a long time for markets to correct, what financial strategy should you use to take advantage of the over-valued dollar?



COMMENTS (3 to date)
Grant's IRO writes:

James Grant featured the 'Dollar Debasement Index' (in place of Kerry's 'Middle Class Misery Index') in his latest Interest Rate Observer. It combines foreign central bank holdings of Treasuries and agencies, the current account deficit, the price of gold and the federal budget deficit. He notes: "The index has risen sharply on Bush's watch, indicating a rapid pace of debasement and latent debasement."

forgetting writes:

I'm not an economist, or very skilled with math, but I find the discussion about the value of the dollar fairly interesting and not inconsequential for Americans who can expect to pay off today's deficits over the long haul.

Today, you may have noticed, Warren Buffet has reportedly acknowledged dollars are a bad currency to hold (so far as Berkshire is concerned anyway). I tried to examine the case a little today in my month-old blog, but don't really have the tools to analyze the implications of currency markets.

I'd like to know how an economist views this apparent 'defection' to expectedly value sustaining currencies.

Off topic and since I'm asking questions at the website of a certified economist, what is the outlook for the shilling in Kenya? Since the election of the anti-corruption styled government, I've been entertaining the notion that Kenya might be an ideal candidate for speculation.

Obasi Philip writes:

Well, I think the investor can do well by buying dollars forward with his funds. This will place him in a better position to enjoy both interest-income differencial and forward premium.

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