Currency values and investment returns

We'll use an example to illustrate how international investment is affected by currency values. The example uses deposit interest rates but the same logic applies to any asset or production facility that generates returns.

Consider two deposit accounts: one in a U.S. bank that pays an interest rate Rus and one in a Mexican bank in peso that pays an interest rate Rmex.

For example, we have $100 to invest, Rus = 5%, Rmex = 5%, and the exchange rate in the beginning of the year is $1 = 5 peso.

If we invest in the U.S., after one year we’ll have $100 * 1.05 = $105.

To invest in Mexico, we first convert $100 into 500 peso and then make a deposit in Mexico. After one year we receive 525 peso. How much is that in dollars?

Case 1. The exchange rate has stayed the same: $1 = 5 peso. We convert the 525 peso into 525 / 5= 105 dollars. In this case the return in dollars is the same in both countries.

Case 2. The peso has depreciated from $1 = 5 peso to $1 = 6 peso. Then, we will receive 525 / 6 = 87.5 dollars, less than in the U.S.

Case 3. The peso has appreciated to $1 = 4 peso. Then we will receive 525 / 4 = 131.25 dollars, more than in the U.S.

In general the difference in returns between the two countries is equal to:

Return differential = (Rus – Rmex) - the percent change in the exchange rate

If the currency of the foreign country in which you invest appreciates, your investment will be even better. If the foreign currency depreciates, this lowers your return.

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