Risks of Carry Trade in Foreign Exchange Markets

Medium Currency Exchange Rates Carry Trade

In the context of currency exchange rates, a carry trade involves borrowing in a currency with a low interest rate and investing in a currency with a higher interest rate.

Consider the following scenario: An investor borrows Japanese Yen (JPY) at an interest rate of 0.25% and uses the proceeds to invest in Australian Dollars (AUD) which provide a yield of 3.25%. The investor anticipates not only profiting from the interest rate differential but also expects the AUD to appreciate against the JPY.

Given this information, which of the following statements accurately describes a potential risk associated with this carry trade strategy?

The risk of the AUD depreciating against the JPY could offset the interest rate gains.

There is no risk involved as the interest rate differential guarantees a profit.

The strategy benefits exclusively from the interest rate spread regardless of currency fluctuations.

Hint

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