Question

you have $AUD5 million . The interest rate on Australian government bonds is 5% while U.S government bonds has an interest rate of 14%. If the US dollar will depreciate by 11% relative to the Aussie dollar. Should you purchase Australia dollar or US dollar

Answer 1

According to International Fisher Effect, the U.S. dollar is expected to depreciate because it has a higher interrest rate. Let's calculate by how much U.S. dollar is expected to depreciate.

The U.S. dollar is expected to change by (1 + Australian bonds interest rate)/(1 + U.S. bonds interest rate) - 1

The U.S. dollar is expected to change by (1 + 0.05)/(1 + 0.14) - 1

The U.S. dollar is expected to change by -0.07894736842 = -7.894736842%

Or the U.S. dollar is expected to depreciate by 7.89%

If the U.S. dollar actually depreciates more than 7.89% (which is the case now at 11%) then we would lose money by investing in U.S. government bonds even though it has a higher interest rate.

So, we will purchase Australia dollar bonds