On May 17, Amy, an American investor, decided to buy three-month Treasury bills. She found that the per-annum interest rate on three-month Treasury bills is 8.00% in New York and 12.00% in London, Great Britain. Based on this information and assuming that tax costs and other transaction costs are negligible in the two countries, it is in Amy's best interest to purchase three-month Treasury bills in to earn more for the three months. because it allows her On May 17, the spot rate for the pound was $1.510, and the selling price of the three-month forward pound was $1.508. At that time, Amy chose to ignore this difference in exchange rates. In three months, however, the spot rate for the pound fell to $1.450 per pound. When Amy converted the investment proceeds back into U.S. dollars, her actual return on investment was
On May 17, Amy, an American investor, decided to buy three-month Treasury bills. She found that the per-annum interest rate on three-month Treasury bills is 8.00% in New York and 12.00% in London, Great Britain. Based on this information and assuming that tax costs and other transaction costs are negligible in the two countries, it is in Amy's best interest to purchase three-month Treasury bills in to earn more for the three months. because it allows her On May 17, the spot rate for the pound was $1.510, and the selling price of the three-month forward pound was $1.508. At that time, Amy chose to ignore this difference in exchange rates. In three months, however, the spot rate for the pound fell to $1.450 per pound. When Amy converted the investment proceeds back into U.S. dollars, her actual return on investment was
Chapter20: Short-term Financing
Section: Chapter Questions
Problem 3BIC
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Transcribed Image Text:Covered versus uncovered interest arbitrage On May 17, Amy, an American investor, decided to buy three-month
Treasury bills. She found that the per- annum interest rate on three-month Treasury bills is 8.00% in New York and
12.00% in London, Great Britain. Based on this information and assuming that tax costs and other transaction costs are
negligible in the two countries, it is in Amy's best interest to purchase three-month Treasury bills in because it allows her
to earn more for the three months. On May 17, the spot rate for the pound was $1.510, and the selling price of the
three-month forward pound was $1.508. At that time, Amy chose to ignore this difference in exchange rates. In three
months, however, the spot rate for the pound fell to $1.450 per pound. When Amy converted the investment proceeds
back into U.S. dollars, her actual return on investment was As a result of this transaction, Amy realizes that there is great
uncertainty about how many dollars she will receive when the Treasury bills mature. So, she decides to adjust her
investment strategy to eliminate this uncertainty. What should Amy's strategy be the next time she considers investing in
Treasury bills? Exchange half of the anticipated proceeds of the investment for domestic currency. Exchange large
amounts of foreign currency for domestic currency. Contract in the forward market to sell the foreign currency in the
amount of the proceeds from the investment. Had Amy used the covered interest arbitrage strategy on May 17, her net
return on investment (relative to purchasing the U.S. Treasury bills) in British three-month Treasury bills would be. (
Note: Assume that the cost of obtaining the cover is zero.)
C
4. Covered versus uncovered interest arbitrage
On May 17, Amy, an American investor, decided to buy three-month Treasury bills. She found that the per-annum interest rate on three-month
Treasury bills is 8.00% in New York and 12.00% in London, Great Britain. Based on this information and assuming that tax costs and other transaction
costs are negligible in the two countries, it is in Amy's best interest to purchase three-month Treasury bills in
, because it allows her
to earn
more for the three months.
On May 17, the spot rate for the pound was $1.510, and the selling price of the three-month forward pound was $1.508. At that time, Amy chose to
ignore this difference in exchange rates. In three months, however, the spot rate for the pound fell to $1.450 per pound.
When Amy converted the investment proceeds back into U.S. dollars, her actual return on investment was
As a result of this transaction, Amy realizes that there is great uncertainty about how many dollars she will receive when the Treasury bills mature. So,
she decides to adjust her investment strategy to eliminate this uncertainty.
What should Amy's strategy be the next time she considers investing in Treasury bills?
O Exchange half of the anticipated proceeds of the investment for domestic currency.
Exchange large amounts of foreign currency for domestic currency.
O Contract in the forward market to sell the foreign currency in the amount of the proceeds from the investment.
Had Amy used the covered interest arbitrage strategy on May 17, her net return on investment (relative to purchasing the U.S. Treasury bills) in
British three-month Treasury bills would be
(Note: Assume that the cost of obtaining the cover is zero.)
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