Reference no: EM132869953
The interest rate on a one-year Treasury bill in the United States is 2 percent and in Europe 6 percent. Provided that, in the absence of any significant news, markets do not expect a change in the dollar/euro exchange rate, US investors can increase their returns by selling US Treasury bills and buying European Treasury bills. In order to invest in Europe they must first change dollars into Euros. The increased demand for Euros causes an appreciation of the euro in relation to the dollar or, alternatively, the dollar depreciates against the euro. The rise in the value of the euro is now generating expectations of depreciation as markets now consider that the euro is overvalued. US investors are having second thoughts as to the realization of capital gains if they shift their funds to Europe.
If markets expect the euro to fall by 3 percent, the return on the European Treasury bill will be 3 percent (6 percent minus 3 percent depreciation). Interest rates are still higher by 1 percent but less capital will flow toward Europe as US investors see that the returns on their investment are now lower than previously. As long as markets are convinced that the euro will appreciate, capital will flow into Europe. When markets believe that the overvalued euro will depreciate by 4 percent, returns are equalized and there are no further incentives to shift funds out of the United States and into Europe.
When financial markets are closely linked, higher interest rates in one country create expectations of depreciation. The argument can be pursued even further. Suppose that expectations are not taken into account and US investors shift their funds into Europe. Once they cash in on their capital gains, they will need to repatriate their profits. In doing so, the demand for dollars increases and the dollar appreciates relative to the euro or, alternatively, the euro depreciates against the dollar.
1. What would you advise investors, and more specifically, US investors, to do terms of investing in Europe?
2. What financial aspects do these investors need to look at before deciding to invest in Europe?
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