Investing Irish Lottery Winnings, Essay Example

Choosing Where To Invest

After winning the Irish Lottery in the amount of €1,000,000.00 on vacation, if I were to immediately exchange my winnings into my home currency of US$ at an exchange rate of US$1 to €.70, I would have US$1,428,571.43.

However, after consideration, I chose to research options for investing my winnings to gain a higher return on my good fortune. I looked into one-year CDs in both Ireland and the US to seek the best possible interest rate for my investment. The CD in Ireland, paying out 2% interest after one year, would leave me with €1,020,000.00. The CD in the US, paying out 4% interest after one year, would net me US$1,485,714.29, a significant improvement over the Irish CD.

While considering my investment options, the exchange rate shifted from US$1 to € .70 to US$1 to € .65. I considered that if I entered into a forward contract in an Irish bank, with plans to exchange to US$ at the end of the contract, I would be able to lock in a stronger exchange rate in addition to the interest rate on my investment. In choosing this course, I would ensure my Irish bank account to be worth US$1,569,230.77 at the expiration of the contract. This choice would be the most profitable to me, netting me an additional return on investment over the US CD with 4% interest by US$83,516.48. This is type of investment, where an investor locks in an exchange rate between two countries, known as covered interest arbitrage.

Covered Interest Arbitrage and Return on Investment

Covered interest arbitrage allows an individual or banking institution to invest currency to take advantage of a strong exchange rate in the global economic market. An investor (or winner) utilizing covered interest arbitrage will maximize their profit by entering into a forward contract. When entering into a forward, an investor locks in the contract date’s exchange rate to be paid out upon the term of the contract; thus allowing the investor to collect at the highest exchange rate possible, once the investment is exchanged back to their home country. In the example as given above, if I entered into a forward and locked my rate at E.65, my investment would be worth US$1,569,230.77, compared to US$1,428,571.43 if I were to have won the €1,000,000 and converted it to a CD when the market was at €.70; leaving my investment in Ireland and locking in a stronger US$ rate nets me an additional return of US$140,659.34. Interest rates are a factor in this equation as well; though in the example as above, it is clear that a lower interest rate doesn’t necessarily equate to a lower return on investment.

Impact of Purchasing Power Parity

“According to the theory of purchasing power parity, the rate of exchange between two currencies is determined by the differences in the price levels of their respective countries,” (Ong, 2003, pg. 1). Essentially, as prices inflate in a market, currency rates depreciate in relation to other country’s currency rates, and vice-versa. Based on this knowledge, we can look at the well-known example of the Big Mac Index. The Big Mac Index theory states the McDonalds’ Big Mac sandwich, a standardized product that should therefore have essentially the same value globally. However, due to purchasing power parity, typically prices vary on the same basket of goods from country to country. For example, if the value of a Big Mac appreciated in a market, thus decreasing the demand for said Big Mac, the value of the currency of that country would depreciate as a result of the increased supply cost in the market. In the example above about Lottery winnings investments, the exchange rate dropped in Ireland during the year of my investment; due to purchasing power parity, we can infer that Ireland experienced an increase in their rate of inflation during the year my winnings were invested.

References

Barker, L. (2002, June). How to calculate currency conversions from dollars to anything. Home page. Retrieved from http://www.ehow.com/how_2167689_calculate-currency-conversions-dollars-anything.html

Ong, L. (2003). The big mac index: applications of purchasing power parity. New York, New York: Palgrave MacMillan Press.

Suranovic, S. (1999, December). Purchasing power parity (PPP), International Finance Theory and Policy, 30, 2-4. Retrieved from International Economics Database.