Impact of NZD Depreciation on Carry Trade Returns

Hard Currency Exchange Rates Carry Trade

Assume that a trader is considering engaging in a carry trade between two currencies: the USD and the NZD. The current spot exchange rate is 0.65 NZD per USD, and the respective interest rates are 2% for the USD and 4% for the NZD. The trader also considers the potential for currency appreciation or depreciation over the period of the trade.

If the trader borrows USD at the lower interest rate and invests in NZD assets at the higher interest rate, what will be the effect on the overall return if the NZD depreciates by 2% during the period of the carry trade?

The overall return will be positive despite the NZD depreciation.

The overall return will be zero as the depreciation offsets the interest rate differential.

The overall return will be negative due to the NZD depreciation outweighing the interest earnings.

Hint

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