carry trade return

CFA Level II
#1

EOC Q3, all-in USD return on the carry trade

[EUR/USDtoday / EUD/USDone year] x (1+EUR LIBOR) -1 - USD LIBOR = 1.04%

why use EUR/USD instead of USD/EUR? Its borrowing in USD to invest in EUR.

because if I use

[USD/EURone year / USD/EURtoday] x (1+EUR LIBOR) -1 - USD LIBOR = 1.05%

I get slightly different number.

Are they identical?

#2

actually they look the same now

#3

but why?

#4

I dont’t get the equation in the first place, can someone help me with that?

[EUR/USDtoday / EUD/USDone year] x (1+EUR LIBOR) -1 - USD LIBOR = 1.04%

#5

Instead of trying to do these formulas, I solve these questions by calculating cash flows. For example, if you want to borrow USD to fund a carry trade into EUR:

Step1: Borrow 100 USD at 3% interest —> pay back 103 at end of cycle

Step2: 100 USD to EUR based on Spot rate --> 102 (just making up a number here, as you didnt post the spots)

Step3: 102 Eur at 5% interest -->107.1 Eur

Step4: 107.1 EUR to USD based on the Forward or future rate --> 104 (just making up a number)

Step5: Pay back the loan of 103 results in a $1 gain

Step6: 1/100 = 1% all in rate

#6

That’s better.

This is, after all, carry trade.

#7

Right!

I always get mixed up with the spots/par/zero rates … and future spot / forwards , etc… Luckily, the questions usually just provide one rate to use :slight_smile: (but not always)

#8

This is way easier to comprehend, thanks!