Suppose that two-year interest rates are 5.2% in the United States and 1.0% in Japan. The spot exchange rate is ¥120.22/$. Suppose that one year later interest rates are 3% in both countries, while the value of the yen has appreciated to ¥115.00/$.

a. Benjamin Pinkerton from New York invested in a U.S. two-year zero-coupon bond at the start of the period and sold it after one year. What was his return?

b. Madame Butterfly from Osaka bought some dollars. She also invested in the two-year U.S. zero-coupon bond and sold it after one year. What was her return in yen?

c. Suppose that Ms. Butterfly had correctly forecasted the price at which she sold her bond and that she hedged her investment against currency risk. How could she have done so? What would have been her return in yen?

AppendixLO1