Explanation:
A carry trade involves a couple of foreign exchange transactions. An investor borrows at the lower interest rate and uses the proceeds to invest in a foreign country with higher interest rates. The difference between the exchange rates and the movement in corresponding currencies contributes to the overall return. Foreign exchange exposure can be hedged or left un-hedged. This lies in the risk manager’s discretion (or overall policy guideline dictates) whether to hedge or not to depending on the forecast.
Formula:
E(FXᵢ) = βᵢ,FX E(HML_FX)
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Q.4551 Maria Gilbert, FRM, is a portfolio manager who has decided to allocate foreign exchange markets in anticipation of high returns. She has identified a carry trade. An emerging market (SER) is offering relatively higher interest rates as compared to current USD rates. Applicable interest rates in the US are hovering at 2%. An emerging market is offering 7% on its government bonds. Maria has decided to allocate $100 million in identified trade, which she intends to carry for a whole year. Maria has compiled the following additional data:
| Variable | Value |
|---|---|
| Exchange Rate at T₀ | SER2.050/US$ |
| Exchange Rate at T₁ | SER2.071/US$ |
| βᵢ,FX | 1.45 |
Calculate foreign carry return for the US portfolio manager.
A
0.0392
B
0.0592
C
0.0568
D
0.0706
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