Today, a U.S. dollar can be exchanged for 3 New Zealand dollars or for 1.6 Canadian dollars. The one-year CD (deposit) rate is 7 percent in New Zealand, is 6 percent in the United States, and is 5 percent in Canada. Interest rate parity exists between the United States and New Zealand and between the United States and Canada. The international Fisher effect exists between the United States and New Zealand. You expect that the Canadian dollar will be worth $.61 at the end of one year.
Karen (based in the United States) invests in a one-year CD in New Zealand and sells New Zealand dollars one year forward to cover her position.
Marcia (who lives in New Zealand) invests in a one-year CD in the United States and sells U.S. dollars one year forward to cover her position.
William (who lives in Canada) invests in a one-year CD in the United States and does not cover his position.
James (based in the United States) invests in a one-year CD in New Zealand and does not cover his position.
Based on this information, which person will be expected to earn the highest return on the funds invested? If you believe that multiple persons will tie for the highest expected return, name each of them. Briefly explain.
The expected returns of each person are as follows:
Karen earns 6 percent due to interest rate parity, and earns the same return as what she could earn locally.
Marcia earns 7 percent due to interest rate parity, and earns the same return as what she could earn locally.
William earns 8.6 percent. If he converts, C$ = $.625 today. After one year, C$ = $.61. So if William invests C$1,000, it converts to $625. At the end of one year, he has $662.50. He converts to C$ and has C$1,086.
James is expected to earn 6 percent, since the international Fisher effect (IFE) suggests that on average, the exchange rate movement will offset the interest rate differential.