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As you can imagine, the presentation of financial statements to top management and the board
at the end of 1985 was far from pleasant. The treasury department had saved $11 million in
interest but lost almost $49 million in the exchange rate accounting.
The CEO was not pleased. The loan was repaid early so the company never saw the gains of
1988 and 1989.
Lesson: Borrowing in a foreign currency can generate similar risks to investing in assets or joint
ventures. The history can be used as an indication, but the greatest risk comes from major moves in
exchange rates that are not anticipated.
Theory: Interest Rate Parity
Interest rate parity theory says that over very long periods of time, the cost of money should equalize
between countries after adjusting for exchange rate changes. Interest rates and changes in the value of
the principal should be considered. In our examples, both the interest rate and the principal would
change in terms of the home currency as a result of economic factors and exchange rate movement.
Neither the Japanese loan nor the English CD actually worked out to be the same as the U.S.
alternative. However, this theory would have led to more analysis if it had been considered.
If inflation is higher in one country than in another, we would expect the low-inflation country to
have low interest rates. At the same time, we would expect the high-inflation country to have high
interest rates. If investors in one country perceive that they can earn a higher return in another country,
they will move their money and invest in the other country, just as Rodney did with the investment in
England. The key is to correctly guess what will happen to exchange rates. Unfortunately, in many
cases, there are large unexpected movements.
Money will flow toward the country with the greatest expected returns and that will put downward
pressures on these returns. If the reverse happens and money flows to where the earned interest rates
are lower, it is a signal that the market as a whole is expecting that currency to strengthen.