Question

During a certain year, the rate of interest on a British deposit was 12 percent while the same on a U.S. deposit was 8 percent. This motivated a few big U.S. investors to invest in British deposits. However, after a year, the U.S. investors received lower rates of return on the British deposits compared to the U.S. deposits. Explain two possible reasons for this outcome

Answer 1

The main reasons are:

• The US dollar appreciated relative to the British pound after the investments were made.
  • Due to this, when the amount was converted from pounds to dollars, fewer dollars were received - the dollar became costlier to purchase.
• Inflation rate was higher in Britain than in US
  • Due to this, the real rate of return in Britain was actually lower than USA.
• Tax rates on foreign earnings were very high in USA
  • Due to this, the earnings from foreign countries like Britain were taxed at such a high rate that the rate of return became lower.
• Transaction costs of converting foreign assets to domestic assets were very high
  • Due to this, when the investor tried to convert pounds to dollars, the conversion itself was a costly process.

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Out of the above mentioned reasons, generally exchange rate fluctuations and tax rates make foreign investments quite risky.

The interest rate difference is about 1/3rd (between 8% and 12%), or a 33% change. If any of the above mentioned factors account for more than a 33% change, it will nullify the interest rate advantage.

For example, if tax rates on foreign earnings are 35%. Or, if the US dollar appreciates by 40%.