Understanding the Risks of Carry Trades

Very Hard Currency Exchange Rates Carry Trade

In recent months, the currency markets have witnessed significant fluctuations due to varying interest rates set by central banks around the world. Investors have been actively engaging in carry trades, where they borrow funds in a currency with a low-interest rate and invest in assets denominated in a currency with a higher interest rate with the expectation of profiting from the interest rate differential and potential capital appreciation.

The following scenario presents a comparison of two carry trades:

Currency A has an interest rate of 1% and is expected to appreciate relative to Currency B, which has an interest rate of 5%. Meanwhile, the current spot exchange rate is 1.20 for Currency A per Currency B. A trader decides to execute a carry trade by borrowing Currency A and investing in Currency B.

Which of the following statements correctly identifies the potential outcomes and risks associated with this carry trade?

The carry trade could result in a positive return if Currency B appreciates significantly, but it exposes the trader to risk if Currency A strengthens.

The carry trade guarantees a risk-free profit due to the difference in interest rates, regardless of any movement in the exchange rate.

The carry trade is always profitable, as borrowing costs will always be outweighed by the returns from investing in the higher-interest currency.

Hint

Submitted4.9K

Correct4.0K

% Correct83%