4. Covered versus uncovered interest arbitrage

On May 31, Kate, an American investor, decided to buy three-month Treasury bills. She found that the per-annum interest rate on three-month Treasury bills is 7.00% in New York and 9.00% in Tokyo, Japan. Based on this information and assuming that tax costs and other transaction costs are negligible in the two countries, it is in Kates best interest to purchase three-month Treasury bills in [ New York / Tokyo] , because it allows her to earn [0.17% / 0.50% ] more for the three months.

On May 31, the spot rate for the yen was $0.100, and the selling price of the three-month forward yen was $0.099. At that time, Kate chose to ignore this difference in exchange rates. In three months, however, the spot rate for the yen rose to $0.102 per yen.

When Kate converted the investment proceeds back into U.S. dollars, her actual return on investment was [-1.50% / 1.50% / -2.50% / 2.50%] .

As a result of this transaction, Kate realizes 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 Kates strategy be the next time she considers investing in Treasury bills? [pick from the bolded list below]

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 foreign currency.

Exchange half of the anticipated proceeds of the investment for domestic currency.

Had Kate used the covered interest arbitrage strategy on May 31, her net return on investment (relative to purchasing the U.S. Treasury bills) in Japanese three-month Treasury bills would be [-1.50% / -0.50% / 1.50% / 0.50%] . (Note: Assume that the cost of obtaining the cover is zero.)