Because the Chilean peso appears to be undervalued relative to the British pound and is likely to rise, Chilean bond yields may be lower than they should be relative to British bonds.
Is anyway able to explain this intuitively? Is it just that appreciating CCY is inflationary and the inflation component of bond yields rises?
Suppose that CLP/GBP is 994.75 when it ought to be, say, 905. Then a bond with a par value of CLP 100,000, selling at par, will cost GBP 100.53 (= 100,000 ÷ 994.75) when it should cost GBP 110.50 (= 100,000 ÷ 905). It’s possible (likely?) that British investors in Chilean bonds will bid up the price to, say, 105.50 (roughly splitting the difference), which is still a bargain compared to what it should cost. That corresponds to a price of CLP 104,946 (= 105.50 × 994.75). Higher price, lower yield.
VoilĂ !
(Note that this isn’t intuition; it’s understanding.)
Ah, arbitrage.
thanks thats very clear. so should that apply to all financial assets? Meaning if a CCY is “undervalued” then in theory every domestic financial asset in that country, denominated in that CCY, may also be undervalued…or every asset really
I don’t see why not.