Question

6. Covered versus uncovered interest arbitrage On June 5, Ginny, an American investor, decided to buy six-month Treasury bills. She found that the per-annum interest rate on six-month Treasury bills is 7.00% in New York and 11.00% in Frankfurt, Germany. Based on this information and assuming that tax costs and other transaction costs are negligible in the two countries, it is in Ginny’s best interest to purchase six-month Treasury bills in , because it allows her to earn more for the six months. On June 5, the spot rate for the euro was $0.820, and the selling price of the six-month forward euro was $0.822. At that time, Ginny chose to ignore this difference in exchange rates. In six months, however, the spot rate for the euro fell to $0.818 per euro. When Ginny converted the investment proceeds back into U.S. dollars, her actual return on investment was . As a result of this transaction, Ginny realized 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 Ginny’s strategy be the next time she considers investing in Treasury bills

Answer 1

Complete question:

•Covered versus uncovered interest arbitrage.

1) On June 5, Ginny, an American investor, decided to buy six-month Treasury bills. She found that the per-annum interest rate on six-month Treasury bills is 7.00% in New York and 11.00% in Frankfurt, Germany. Based on this information and assuming that tax costs and other transaction costs are negligible in the two countries, it is in Ginny’s best interest to purchase ________ six-month Treasury bills in , because it allows her to earn _________more for the six months.

2) On June 5, the spot rate for the euro was $0.820, and the selling price of the six-month forward euro was $0.822. At that time, Ginny chose to ignore this difference in exchange rates. In six months, however, the spot rate for the euro fell to $0.818 per euro. When Ginny converted the investment proceeds back into U.S. dollars, her actual return on investment was _________.

3) As a result of this transaction, Ginny realized 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 Ginny’s strategy be the next time she considers investing in Treasury bills

Answer:

1) German (Frankfurt) ; 2%

2) 1.7%

3) Ginny's strategy should be to contract in the forward market to sell the foreign currency in the amount of the proceeds from the investment.

Explanation:

1) Per annum rate on 6-month treasury bill:

• New york = 7.00% /year =>

7%/2 = 3.5% for ½ a year(6 months)

• Frankfurt = 11% /year =>

11%/2 = 5.5% for ½ a year(6 months)

Interest rate difference =

5.5% - 3.5% = 2.0%

Ginny should purchase the Frankfurt treasury bill because it has a 2% higher interest rate than the American treasury bill on on six-month, since tax costs are negligible.

In Ginny's best interest, she should purchase the German (Frankfurt) treasury bills, because it allows her to earn 2% more for the first six months.

2) spot rate = $0.820

Selling price = $0.822

After six months, new spot rate = $0.818

After converting his actual return will be:

(Newrate - old rate)/old rate

$\frac{0.818-0.820}{0.820} = 1.7$

3) Ginny's strategy should be to contract in the forward market to sell the foreign currency in the amount of the proceeds from the investment, since she wants to eliminate the uncertainty of how many dollars she will receive when the treasury bills mature