Suppose that annualized interest rates on 3 month CD’s in the U. S. are .375 % w

Question

Suppose that annualized interest rates on 3 month CD’s in the U. S. are .375 % while in the Australia annualized interest rates on 3 month deposits are 1.10%.

a) What must currency traders expect to happen to the exchange rate of the US $ in terms of the amount of Australian $ it buys over the next three months if there is equilibrium in the currency markets at this interest rate differential? You may assume that currently 1AUS $ is worth 75 US cents.   For full credit, you need an exact answer.  

b) In currency markets the “carry trade” refers to borrowing in a currency with low short term interest rates, exchanging that currency for one with higher yielding short term financial instruments and investing in those higher yielding instruments. Why is this considered to be a “risky” trade?

Explanation / Answer

b. Carry trading is one of the simplest strategies for currency trading that exists. A carry trade is when a forex dealer buys a high-interest currency against a low-interest currency. For each day that the dealer holds that trade, he receives the interest difference between the two currencies, as long as the trade is in the interest positive direction.

The following list includes some of the primary risks commonly associated with carry trades.

Currency Risk: Since carry trades are generally held unhedged, it means that any return from the interest rate differential needs to be in excess of any adverse exchange rate movements in the carry trade currency pair. As a result, a currency pair usually is chosen for the carry trade for which the trader forecasts the higher interest rate currency will appreciate over the chosen time frame relative to the lower interest rate currency.

Leverage Risk: An important risk factor for retail forex traders to consider carry trade is that if substantial leverage is used to implement it, then sharp unfavorable market movements could result in losses that may prompt margin calls or the position being automatically stopped out by your forex broker.

Interest Rate Shift Risk: When carry traders seek to compound their interest on a monthly or even daily basis to increase their overall returns, they can then be subject to returns that can vary depending on movements in the interest rate differential.

To cite through an example, if the interest rate differential widens, this will generally be a move in the carry trader's favor, which they can take advantage of in the next compounding period. On the other hand, when interest rate differentials narrow, the carry trader will then receive a lower return than anticipated in their next interest compounding period.

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