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Notes-Carry - Trade Copy 7

Currency carry trade is a strategy where investors borrow funds in a currency with a low interest rate, convert it to a currency with a higher interest rate, and earn the difference between the interest rates. The main risk is exchange rate risk, as fluctuations in exchange rates can cause losses if the low interest rate currency increases in value versus the high interest rate currency. For example, an investor can borrow $1 million at 1% interest in US dollars, convert it to British pounds at a 5% yield, and earn a $40,000 profit if exchange rates remain constant when closing the transaction.

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Shravan Venkataraman
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36 views2 pages

Notes-Carry - Trade Copy 7

Currency carry trade is a strategy where investors borrow funds in a currency with a low interest rate, convert it to a currency with a higher interest rate, and earn the difference between the interest rates. The main risk is exchange rate risk, as fluctuations in exchange rates can cause losses if the low interest rate currency increases in value versus the high interest rate currency. For example, an investor can borrow $1 million at 1% interest in US dollars, convert it to British pounds at a 5% yield, and earn a $40,000 profit if exchange rates remain constant when closing the transaction.

Uploaded by

Shravan Venkataraman
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Page 58

Carry Trade

Currency carry trade, also called open interest arbitrage, is another arbitrage
strategy that takes advantage of the difference between the interest rates of two
different currencies. In a currency carry trade, investors borrow in the low-
interest currency and convert it into the high-interest currency. They then lend in
the high-interest currency. On maturity, they buy back the low-interest currency.
The profit is the difference between the interest rates of the two currencies.

The biggest risk in a currency carry trade is exchange rate risk. Fluctuations in the
exchange rate can cause losses if the low-interest currency becomes more
expensive when buying back.

The carry trade is not an arbitrage, but a strategy used by currency traders. They
borrow in one currency with a low interest rate and then use the funds to buy a
different currency that is paying a higher interest rate. In addition to earning an
interest rate differential due to the difference between the two currencies, there
is also a chance that the currency they purchased will appreciate. However, this
strategy can be risky because the trader’s profit depends on the exchange rate
remaining the same until the transactions are completed.
Page 59

For example, suppose the annual interest rate on US dollars is 1%, the interest
rate on British pounds is 5%, and the exchange rate of GBP-USD is 1.6833. An
arbitrageur can borrow $1,000,000 at 1%, convert it to £594,071, and then buy a
one-year GBP bond that yields 5%. On maturity, the bond will return 623,775
GBP. Assuming the exchange rate is constant, he can then sell the pounds to buy
$1,050,000. After paying back the $1,000,000 million with 1% interest, he would
have a $40,000 profit.

For a carry trade to be profitable, the exchange rate must not move adversely
against the currency with the higher interest rate. In the above example, if the
GBP-USD exchange rate decreases, (i.e., the USD becomes more expensive) the
carry trade will be less profitable.

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