Hedging a foreign investment can in effect erase cross border capital flows. to illustrate, suppose and American pernsion funds buys one million dollars worth of Indonesian rupiah denominated bonds. this is a foreign investment in the capital market of Indonesia; it brings in dollars to Indonessia. Now suppose the pension fund goes to the currency market and sells forward, for dollar, the prospective rupiah proceeds from the bonds. Then on the basis of that collateral it draws dollar in spot market operated by Indonesian banks. Thus, the circle is completed, and dollar flows out of Indonesia, back to New York, whle the American pension fund continues to own the Indonesian bonds. So American investors in this example, can take position in foreign securities without causing any net outflow of capital from the US.
Why should an investor do such a roundabout excursion [don't myself follow the rest--rb]? In a situation where the covered interest rate parity holds an arbitrage of this type reduces exchange risk, but does not add to profit. However, the presence of risk premium in currency and capital markets can carve out scope for profit making. Suppose that the rate of return on Indonesian bonds is high, at 20%. there are risks, no doubt; but neither the balance of payment of the country nor the income statment of a company records risks. In the US the rate of return is relatively low, say 5%. I fthe rupiah is fairly steady an American investor can make almost instant profit, of 15 percent, by taking oa position on Indonesain bonds without any net expenditure of dollars., relying on the above mentioned scheme of currency transactions. This is the essence of what is known as the Feldstein paradox."
Any further elaboration of the Feldstein paradox would be appreciated. Brad, Chris, Max, Doug? thanks, rakesh