Risk in Carry Trade Evaluation

Medium Currency Exchange Rates Carry Trade

In the context of foreign exchange markets, a carry trade involves borrowing in a currency with a low interest rate and investing in a currency with a higher interest rate, seeking to profit from the differential. This practice assumes that the exchange rates remain stable or move favorably over the investment horizon.

Consider the following scenario: An investor borrows AUD (Australian Dollar) at an interest rate of 1.5% and invests in NZD (New Zealand Dollar) at an interest rate of 2.5%. Over the investment period, the investor also anticipates a potential appreciation of the NZD against the AUD.

Which of the following statements best describes a potential risk associated with this carry trade strategy?

The interest rate differential may become less favorable if Australia raises its rates.

The investor will always benefit from the interest differential regardless of exchange rate movements.

The currency depreciation of the NZD against the AUD will increase the return on investment.

Hint

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