Question

Katy Hegel works for Magnum Partners, a hedge fund in Boston. She can invest up to U.S. in a single transaction. She specializes in carry trade transactions and notices a por portunity involving borrowing USD and investing in Australian dollars. The current interest rates and exchanges rates are: Australian invest rate: U.S. borrow rate Spot exchange rate Forward rate 5.25% p.a. 3.75% p.a. USD.8937/AUD USD.8810/AUD a. If Katy expects the USD/AUD exchange rate to stay about the same over the next year, how much profit would he make on the carry trade if she invests in AUD for one year? b. If she covers the transaction with a forward contract how much profit would she make? c. What should Katy do?

Answer 1

	AUD INVEST RATE	5.25
	US BORROW RATE	3.75
	SPOT EXCHANGE RATE	0.8937	USD / AUD
	FORWARD EXCHANGE RATE	0.881	USD / AUD
	AMOUNT TO BE INVESTED	$                         5.00	MN
A
	AMOUNT TO BE INVESTED (USD)	$        5,000,000.00
	SPOT EXCHANGE RATE	0.8937	USD / AUD
	AMOUNT TO BE INVESTED (AUD)	AUD 5,594,718.59
	INTERESST ON AUD INVESTMENT @ 5.25%	AUD 293,722.73
	TOTAL AMOUNT AFTER ONE YEAR	AUD 5,888,441.31
	AMOUNT CONVERTED TO USD AT SPOT RATE	$        5,262,500.00
	LESS
	AMOUNT INVESTED	$        5,000,000.00
	INTEREST ON USD FUNDS @ 3.75%	187,500.00
	TOTAL	5,187,500.00
	PROFIT =	75,000.00
B	PROFIT IF TRANSACTION IS COVERED WITH A FORWARD RATE
	AMOUNT TO BE INVESTED (USD)	$        5,000,000.00
	SPOT EXCHANGE RATE	0.8937	USD / AUD
	AMOUNT TO BE INVESTED (AUD)	AUD 5,594,718.59
	INTERESST ON AUD INVESTMENT @ 5.25%	AUD 293,722.73
	TOTAL AMOUNT AFTER ONE YEAR	AUD 5,888,441.31
	AMOUNT CONVERTED TO USD AT FOREWARD RATE	$        5,187,716.80
	LESS
	AMOUNT INVESTED	$        5,000,000.00
	INTEREST ON USD FUNDS @ 3.75%	187,500.00
	TOTAL	5,187,500.00
	PROFIT =	216.80
C
	KATY SHOULD GO AHEAD WITHOUT A FORWARD COVER IF EXCHANGE
	RATE ARE EXPECTED TO BE SAME AFTER ONE YEAR
	HOWEVER, THIS IS A VERY RISKY PROPOSITION AS IF EXCHANGE RATE
	FLUCUATUTE TO HER DISADVANTAGE, THEN LOSS IS UNLIMITED
	IF TRANSACTION IS COVRED WITH A FORWARD COVER, THERE IS A
	MARGINAL PROFIT ONLY WHICH IS INSIGNIFICANT