A carry trade is a strategy that involves borrowing at a low interest rate and investing in an asset that provides a higher rate of return. In the context of foreign exchange markets, a carry trade involves borrowing in a low-yielding currency (funding liability) and investing in a high-yielding currency (target asset). The investor 'carries' the difference between the two rates. Carry trades are typically used by large hedge funds and are a major source of leverage in the foreign exchange market.

Choice B is incorrect. Cross currency funding refers to the process of borrowing in one currency where rates are low and then using that funding to invest in another currency where returns are high. While this may seem similar to the scenario described, it does not involve an investor possessing a target asset that yields high returns. Instead, it involves direct investment in a different currency.

Choice C is incorrect. Hedging is a risk management strategy used by investors to protect against potential losses from fluctuations in exchange rates, interest rates or commodity prices. It does not involve financing an asset with a liability as described in the question.

Choice D is incorrect. The funding gap refers to the difference between available funds (liabilities) and required funds (assets). This concept does not involve investing or financing assets with liabilities as described in the question.

Things to Remember

• Carry trade involves borrowing in a low-yielding currency and investing in a high-yielding currency to profit from the interest rate differential.
• Interest rate parity is an important concept related to carry trades, stating that the forward exchange rate should incorporate the interest rate differential between two currencies.
• Uncovered interest rate parity (UIP) is another concept relevant to carry trades, suggesting that expected exchange rate changes should offset interest rate differentials.