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CFA Level 2
Economics

Evaluating the Overall Return on a Carry Trade

Very Hard Currency Exchange Rates Carry Trade

In the context of currency trading, a carry trade involves borrowing funds in a currency with a low interest rate and investing those funds in a currency that offers a higher yield. Assume an investor notable in the currency markets borrows Japanese yen (JPY) at an interest rate of 0.1% and uses those funds to purchase Australian dollars (AUD), which yield 4.5% annually. After a year, the exchange rates change such that 1 AUD = 90 JPY at the moment of borrowing, and later, 1 AUD = 85 JPY at the time of unwinding the trade.

Considering the impact of interest rate differentials and exchange rate fluctuations, what would be the overall return of this carry trade for the investor?

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