Reader Daniel Akst of Germantown, NY akts, er, asks: It says in the papers that interest rates in Japan are under one percent. U.S. Treasury bills currently pay almost five percent. Why isn't everybody borrowing money in Japan and investing it in the United States? It seems like a sure thing.
Answer: The only sure thing is that it's not so easy. What this calculation overlooks is fluctuations in the exchange rate. Say you borrow a million yen at one percent and convert them (at an exchange rate of 120 yen/dollar) into $8333. You invest at five percent, yielding $8750 after one year. That's a four-percent spread: nice. But at the end of the year you've got to convert your dollars back to yen to repay the Japanese bank. If the exchange rate is now 115 yen/dollar, you must fork over the entire $8750 in exchange for the 1,010,000 yen required to pay off your loan. The whole thing's a wash (not even considering the transaction costs). A falling exchange rate wipes out your profit because you get fewer yen when you cash in your dollars at year's end.
But, wait a minute, you may be saying, what reason is there to assume that a fluctuating exchange rate will coincidentally guarantee that Dan Akst's investment will be a wash? The answer is that it's not a coincidence. Market pressure will lead to this result. And the agents of market pressure are investors known as arbitrageurs.
Suppose that for some reason market prices were "wrong"--that they wandered off the path that would make Dan Akst's "sure thing" a wash. Arbitrageurs, sensing that it was not a wash, would borrow lots of yen and convert them to dollars in order to buy U.S. bonds. In the process, the yen-dollar exchange rate would change, because a surge in demand (for dollars) drives up the price (in yen). In fact, these arbitrageurs won't stop borrowing yen and converting them to dollars until the whole thing is a wash again.
So at any given moment, today's exchange rates are going to be whatever it takes to make Dan Akst's bet on future exchange rates a wash--based on the arbitrageurs' best judgment and current information about the future. When new information comes in--a speech by Alan Greenspan, a flood in St. Louis, and so on--a "sure thing" momentarily appears and, as arbitrageurs seize it, is instantaneously wiped out.
It's possible that arbitrageurs will misguess the future exchange rate. And you're free to gamble that they're wrong, but you've left the dreamland of the sure thing.
Sorry, Dan. Next question?