Avoid investment in foreign institutions. Exchange large amounts of foreign currency for domestic currency. Dina realizes that her actual return (-2.97%) is less than her expected return (1.00%) and decides to use a strategy known ascovered interest arbitrageto eliminate the uncertainty over how many dollars she receives when the foreign currency is reconverted into dollars. That is, should she invest in foreign Treasury bills again while exchanging dollars for foreign currency to finance the investment, she would also contract in the forward market to sell the amount of foreign currency expected as proceeds from the investment with a delivery date to coincide with the maturity of the investment. Had Dina 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-1.13%. (Note: Assume that the cost of obtaining the cover is zero.) Had Dina used covered interest arbitrage, she would need to take into account not only information on foreign and domestic interest rates, but also all available information on spot and future exchange rates to calculate the net rate of return on investment in British three-month Treasury bills. To calculate Dina’s net rate of return on investment, start with the following formula: Therefore, using covered interest arbitrage, Dina would have received a net return on investment in three-month Treasury bills of0.90%, which is greater than the return with uncovered interest because, by using uncovered interest arbitrage, Dina actually lost more than she had gained on the difference in interest rates in London and New York. In addition, Dina should have only invested in three-month British Treasury bills if the interest-ratedifferentialin favor of British Treasury bills exceeded the cost of obtaining the forward cover. Here, it was assumed to be zero, but in real-world situations, it is costly. 1. Study Questions #1. Ch 11.
