If the dollar interest rate is 10 percent, the euro interest rate is 12 percent, then an investor should invest only in euros.
The correct answer and explanation is:
Correct Answer: False
The decision to invest solely in euros cannot be made based on interest rate differences alone. While the euro interest rate of 12 percent is higher than the dollar interest rate of 10 percent, this does not automatically mean that investing in euros is better. Other crucial factors need to be considered, particularly the expected exchange rate movement between the euro and the dollar.
Interest rate parity is a key concept that helps evaluate such investment decisions. According to uncovered interest rate parity, the difference in interest rates between two countries is typically offset by the expected change in the exchange rate. For example, if the euro offers a higher interest rate than the dollar, the euro may be expected to depreciate relative to the dollar. If the euro does depreciate by approximately 2 percent, it would offset the higher interest earnings, making the returns equivalent in dollar terms.
Moreover, investors face exchange rate risk when investing in a foreign currency. If an investor from the United States puts money into euro-denominated assets and the euro loses value against the dollar during the investment period, the returns could be lower than expected when converted back to dollars. Even with a higher nominal interest rate, the actual return could be reduced or become negative depending on currency movements.
In addition, factors like inflation, country risk, and monetary policy should also be taken into account. For instance, a higher interest rate in euros might reflect higher inflation expectations or increased risk, which could affect the real return.
In conclusion, while the euro interest rate is higher in nominal terms, it does not mean an investor should automatically invest only in euros. A proper investment decision should include consideration of exchange rate expectations and other economic conditions.