Problem
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 Canada or Japan, but as a Canadian resident, you want your investment return to be in Canadian dollars. Assume the current interest rate on one-year government bonds is 3% in Canada and 7% in Japan, the current exchange rate is yen 100 = $1, and the expected exchange rate in one year is yen 110 = $1.
a. What is your return on Japanese bonds?
b. Would you have been better off investing in Japanese bonds or Canadian 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?