Explanation:
The fund manager borrows in one currency, converts the currency into another currency, and invests the converted amount in the country with a higher interest rate. Thus, the profit generated in the transaction can be reduced/affected in case the exchange rate changes.
Things to Remember
The strategy described in the question is known as a 'carry trade'. In a carry trade, an investor borrows money in a country with a low interest rate and invests it in a country with a high interest rate, hoping to profit from the interest rate differential.
While the carry trade can be profitable, it is not without risks. The main risk is exchange rate risk. If the currency of the country where the funds were borrowed appreciates against the currency of the country where the funds were invested, the amount to be repaid in the original currency will be higher, reducing the profit or causing a loss.
Other risks associated with the carry trade include political risk, economic risk, and liquidity risk. Political risk refers to the risk that a change in government policy could affect the profitability of the trade. Economic risk refers to the risk that changes in the economic conditions of either country could affect the trade. Liquidity risk refers to the risk that the investor may not be able to quickly and easily convert the investment back into the original currency.
Q.4453 Consider a hypothetical world of two countries only. A fund manager borrows funds from a country with interest rate X and invests in another country with interest rate Y, where X < Y. He intends to generate profit from the interest differential between the two countries. The major risk in this strategy is:
A
None – it's a riskless strategy.
B
The interest differential may increase.
C
The exchange rate of the currencies may change.
D
None of the above.
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