THE ISSUES

Most investments are uncertain. They must be based on forecasts about future earnings, and forecasts can be wrong. Foreign investments are especially uncertain, because they involve forecasts about exchange rates, as well as forecasts about earnings. International capital movements depend not only on interest-rate differences but also on investors' expectations about future exchange rates. Furthermore, they are influenced by attitudes toward risk, which affect an investor's willingness to make commitments in an uncertain world.

This chapter introduces expectations and uncertainty into the analysis of capital movements. It begins by examining three issues:

• How exchange-rate expectations affect an investor's choice between foreign and domestic bonds.

• How that choice is influenced by attitudes toward risk.

• How expectations about future exchange rates affect the functioning of the foreign-exchange market.

We will see that speculation links the actual exchange rate today with the rate expected in the future and that it can contribute to exchange-rate stability.

Thereafter, the chapter introduces the forward foreign-exchange market and examines two more issues:

• How traders and investors use the forward market to protect themselves against exchange-rate risk.

• How speculators use the forward market to place “bets” on their views about future exchange rates and deliberately incur exchange-rate risk.

We will see that the forward market allows traders and investors to shift risk to speculators.

EXPECTATIONS AND RATES OF RETURN

Let there be two bonds, a domestic bond bearing an interest rate r and denominated in domestic currency, and a foreign bond bearing an interest rate r* and denominated in foreign currency.