Suppose the interest rate on 6-month treasury bills is 7 percent per year in the United Kingdom and 4 percent per year in the United States. Also, today's spot exchange price of the pound is $2.00 while the 6-month forward exchange price of the pound is $1.98. Consider the expected future spot rate of pounds is $2.04. By investing in U.K. treasury bills rather than U.S. treasury bills, and NOT covering exchange-rate risk, the approximate extra return earned by U.S. investors for 6 months will be:

Question

Quizplus · Accepted Answer

To calculate the extra return earned by U.S. investors for 6 months, we need to first calculate the returns on U.K. and U.S. treasury bills separately.

Return on U.K. treasury bills for 6 months = (7%/2) = 3.5%
Return on U.S. treasury bills for 6 months = (4%/2) = 2%

Now, if a U.S. investor invests in U.K. treasury bills, they will earn a return of 3.5%. However, to convert this return into U.S. dollars, they will need to sell British pounds and buy U.S. dollars at the future spot rate of $2.04. This means they will receive:

(3.5/2) x $2.04/$2.00 = 3.6%

Therefore, the extra return earned by U.S. investors for 6 months by investing in U.K. treasury bills rather than U.S. treasury bills, WITHOUT covering exchange-rate risk, is approximately 3.6%. Thus, the correct answer is D.

Suppose the Interest Rate on 6-Month Treasury Bills Is 7