Consider the case of a U.S. investor holding dollars and deciding whether to invest in Japanese treasury bills or in U.S. treasury bills. Assume that the investor wants to end up holding dollars. What are the three methods available to this investor to turn present dollars into future dollars? In your answer present an equation that shows the return per dollar invested under each method. Which of these methods is the riskiest and why?
What will be an ideal response?
POSSIBLE RESPONSE: The three methods, each described by an equation, per $1 invested, are:
a. Covered international investment; covered return = (1 + iJP) × (f / e)
b. Uncovered international investment; expected uncovered return = (1 + iJP) × (eex / e)
c. Invest directly in U.S. treasury bills; domestic return = (1 + iUS)
Here, iJP = interest rate in Japan, iUS = interest rate in the U.S., e = spot exchange rate, f = forward exchange rate, and eex = expected future exchange rate.
The riskiest is the second option because the investor is exposed to exchange-rate risk and is not covered.
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