Covered versus uncovered interest arbitrage on May 17, George, a U.S. investor,
ID: 2766497 • Letter: C
Question
Covered versus uncovered interest arbitrage on May 17, George, a U.S. investor, decided to buy three-month Treasury bills. He found that the per-annum interest rate on three-month Treasury bills is 8.00% in New York and 12.00% in London. Based on this information and assuming that tax costs and other transaction costs are negligible in the two countries, it is in George's best interest to purchase three-month Treasury bills, because it allows him 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, George chose to ignore this difference In exchange rates. In three months, however, the spot rate for the pound fell to $1.450 per pound. Thus, when George converted the investment proceeds back into U.S. dollars, his actual return on investment was. As a result of this transaction, George realizes that there is great uncertainty about how many dollars he will receive when the Treasury bills mature. So, he decides to adjust his investment strategy to eliminates this uncertainty. What should George's strategy be the next time the considers investing in Treasury bills? Exchange large amounts of foreign currency for domestic currency. Sell enough foreign currency on the forward market to match the anticipated proceeds from the investment. Exchange half, of the anticipated proceeds of the investment for domestic currency. Had George used the covered interest arbitrage on May 17, net return on investment (relative to purchasing the U.S. Treasury bills) in British three-month Treasury bills would be.Explanation / Answer
Answer (a)
It is in George's Best Interest to Purchase London three months Treasury Bills, because it allows him to earn 1% more for the three months.
Answer (b)
Answer (c)
George's Strategy for the next time should be to Sell enough foreign currency on the forward market to match the anticipated proceeds from the investment. In the Present case He should have sold 3 month Pound in Forward market at forward rate of $1.508 per Pound.
Answer (d)
Ans
Particulars New York London Interest Rate Per Annum 8% 12% Maturity of Treasury Biil 3 months 3 months Interest to be earned in 3 months Treasury Bill 8%*3/12 ; 12%*3/12 2% 3%