Why people buy foreign bonds when foreign interest rate raises?

Question

I'm reading Investopedia's How National Interest Rates Affect Currency Values and Exchange Rates to understand how interest rates affect exchange rates.

It says:

Generally, higher interest rates increase the value of a country's currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country's currency.

And:

When the Federal Reserve raises the federal funds rate, interest rates across the broad fixed income securities market increase as well. These higher yields become more attractive to investors, both domestically and abroad.

I don't fully understand this.

In what follows EUR/USD exchange rates are taken from FRED, Federal Funds Effective Rate are also taken from FRED, and ECB interest rate are taken from ECB website.

Suppose I'm a EU citizen, and in August 2006 I have $100 €$.

For the sake of simplicity, suppose I invest at the ECB interest rate, which in 2006 was 3%. I invest it for 5 years. In August 2011 I have $100\cdot(1+0.05)^5=115.93 €$. I gained $15.93 €$ in interests.

In August 2006 the FED had just risen interest rates. In fact FED's rate equal $5.25\%$, more than ECB rate.

I then convert my EUR in USD. The exchange rate EUR/USD in Aug 2006 equals $1.2793$. My $100€$ are then converted to $ 100€*1.2793\frac{$}{€}=127.93\,{$} $. I invest in 5 years at FED's rate. In August 2011 I have

\begin{equation} 127.93\,{$} \cdot (1+0.0525)^5 = 165.23\, {$} . \end{equation}

Now I'm in Europe and Europe's sellers want euros. So I convert my dollars back in euros. In August 2011 the EUR/USD exchange rate is $1.4406$.

I then have $$ 165.23\,{$} \div 1.4406 \frac{$}{€} = 114.69 € .$$

I gained $14.69 €$ in interests, $1.23 €$ less than what I have gained if I had invested in euro-denominated bonds.

Said otherwise, if my buying USD bonds increase the exchange rate, either I transfer to the US at maturity or the higher exchange rate will go against me at maturity.

Where am I wrong?

Answer 1

There are a lot of false assumptions here. A probably incomplete list:

• You (implicitly) assume is that the Investopedia article is telling the whole story (Investopedia is not particularly reliable)
• The statement refers to the time period you are looking at
• You get the same short term interest rate for a period of 5 years
• The FED Funds Rate and USD bonds do have the same interest rate.

In reality:

• The Feds Funds rate is an overnight rate that changes constantly (that you as a retail investor could not even invest in).
• Higher interest rates increase the value of a currency immediately, not over a period of time.
• In fact, higher interest rates will lead to a decline in the FX rate over time (according to interest rate parity).
• Exchange rates do not simply follow such a pre-determined path (even if interest rates would never again change). They largely, and especially in the EURUSD example follow a random walk (details here).
• There is a Cross Currency Basis when trading floating rates between currencies because no one can actually borrow and lend freely in USD (what rate even? SOFR, Fed Funds, Libor pre cessation date, Euribor, ESTR,...)