Carry Trade - when to use Bid or Offer

CFA Level II
#1

Hey guys,

I’ve seen conflicting opinions on this and I wanted to get some confirmation here.

Let’s say we enter into a carry trade borrowing EUR at 3%, and we will invest in USD at 5%. We are given the USD/EUR bid-offer of .8500-.8600. The expected spot in a year is .8700 USD/EUR. So is this the way the carry trade would play out (assume we borrow EUR 100):

EUR 100\ *.8600 = 86USD OFFER because we are BUYING USD

100*(1.03) = 103 EUR

86 USD*1.05/.87 = 103.8 EUR

Profit = 0.80 EUR

Can someone please confirm if we do in fact use the offer here? It seems like we would always use the offer because we are always buying the currency we are lending. I appreciate the feedback.

#2

You always – _ always! _ – use the number that will give you the lower amount of the new currency.

In your example the quote is not to buy or sell USD; it’s to buy or sell EUR: the base currency. So you use 0.8500, getting USD85, not USD86. You get the lower amount.

#3

You cleared a lot up for me, thank you so much.

#4

And once you get the profit/ loss, what do you do to calculate the total carry trade profit?

Schweser lists the formula as return on investment - borrowing cost - currency depreciation. So it would be 5%-3%+0.5 in this case? $2000magician, can you help out?

#5

Here goes:

  1. Borrow EUR100 for one year at 3%
  2. Convert EUR100 at USD/EUR 0.8500 to USD85
  3. Invest USD85 for one year at 5%; value grows to USD89.25
  4. Convert USD89.25 at USD/EUR 0.8700 to EUR102.59
  5. Pay off loan at EUR103
  6. Net _ loss _ is EUR0.41

Not the best investment I’ve ever made, but certainly not the worst.

Note that the IRP forward rate is USD/EUR 0.85(1.05/1.03) = USD/EUR 0.8665. So if we expected 0.87 we should never have entered into the trade; we’d expect from the outset that we were going to lose money.

#6

That really helped!! Thank you so very much, S2000magician,