EECS 1710 Lecture 24: EECS 1710 Lecture 24 Notes
24 Jun 2018
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EECS 1710 Lecture 24 Notes
Introduction
Impact of Appreciation in the Investment Currency
The profit of $4,598 to Hampton as a percentage of its own funds used in this carry
trade strategy over a 1-month period is therefore $4,598=$100,000 ¼ 4.598 percent.
Notice the large return to Hampton over a single month, even though the interest rate
on its investment is only .5% above its borrowing rate.
Such a high return on its investment over a one-month period is possible when
Hampton borrows a large portion of the funds used for its investment.
This illustrates the power of financial leverage.
At the end of the month, Hampton may roll over (repeat) its position for the next
month.
Alternatively, it could decide to execute a new carry trade transaction in which it
borrows a different currency and invests in still another currency.
If the British pound had appreciated against both the euro and the dollar during the
month, Hampton’s profits would be even higher for two reasons.
First, if the pound appreciated against the euro, then each British pound at the end of
the month would have converted into more euros and so Hampton would have needed
fewer British pounds to repay the funds borrowed in euros.
Second, if the pound also appreciated against the dollar then the remaining British
pounds held (after repaying the loan) would have converted into more dollars.
Thus, the choice of the currencies to borrow and purchase is influenced not only by
prevailing interest rates but also by expected exchange rate movements.
Investors prefer to borrow a currency with a low interest rate that they expect will
weaken and to invest in a currency with a high interest rate that they expect will
strengthen.
Document Summary
The profit of ,598 to hampton as a percentage of its own funds used in this carry trade strategy over a 1-month period is therefore ,598=,000 4. 598 percent. Thus, the choice of the currencies to borrow and purchase is influenced not only by prevailing interest rates but also by expected exchange rate movements. Investors prefer to borrow a currency with a low interest rate that they expect will weaken and to invest in a currency with a high interest rate that they expect will strengthen. When many investors executing carry trades share the same expectations about a particular currency, they execute similar types of transactions and their trading volume can have a major influence on exchange rate movements over a short period. A percentage of its own funds used in this carry trade strategy over a 1-month period is therefore ,598=,000 4. 598 percent.
