To be honest, this question is kind of an *******, and here’s why:
it is true that the higher the forward premium, the more profitable a carry trade is likely to be. The way the question is worded, however, does not make it clear what the process of events is. Here is the question:
[Question removed by admin]
So here’s the thing - if the guy executes the trade, and THEN the “event” happens, then B would actually be a very bad thing for this guy - he’s gone short on the USD, and a higher forward premium on it means it is appreciating. this is the same thing as if you go short on a stock, and then it goes up in value - it screws you. In option A, (a narrower interest rate differential), this means that either the Indian interest rate is dropping, or the American one is rising, or some combination of the two - either way, PPP will make the USD depreciate against the INR, and conversely, the INR will appreciate. if you’ve executed this trade, you are long the INR, and short the USD - you want the INR to appreciate, and the USD to depreciate, but again, you only want that if you’ve ALREADY EXECUTED THE TRADE. I’ll elaborate: Suppose at the start of the carry trade, the indian rate is 10%, and the US rate is 1%, furthermore, 1 INR = $.10 (or 10 INR = 1). Using PPP, the forward rate on the USD is 10.89 RU [(10x(1.1/1.01)]. Then, assuming the spot prices stay the same, but then the US interest rate goes up to 5% in the USA, then the forward rate on the USD changes to 10.48 RU per - or as I said earlier, a depreciated US dollar (since I now need fewer Rupees to buy a $). So for my carry trade, I get my 10% INR return, which means my 10 rupees have turned into 11 after a year of being invested, and thankfully the USD is available to me at a cheaper price due to that relatively increased US interest rate, so I get an even higher return than my carry trade would have otherwise given me. In other words, if you assume the guy actually does the trade, and then the event happens, the answer is actually A (which is effectively a cheaper US dollar spot price relative to the INR). However, That’s not what’s going in the question. The question is saying that the guy has not done the trade, he’s just looking at it. THEN this event happens. In that case, it is more appealing to have a wider forward premium to work with at the START of the trade, because there is less chance that the spot price of the borrowed currency will appreciate up to a level that erases your returns from investing at the higher interest rate in the discount currency. IF YOU ASSUME THE GUY IS JUST LOOKING AT THE TRADE AND WAITING TO EXECUTE IT, THEN THE ANSWER IS B, WHICH IS WHAT THE CFA ACTUALLY PUT AS THE ANSWER, ie “a more profitable trading opportunity”. It’s sort of like asking the question “a guy is considering buying an $8 stock that he knows for a fact he’ll be able to sell for at least $10 in one month’s time. which event would give him the most profit?” A) stock increases to 13 B) stock decreases to 6 C) something stupid Assuming the guy hasn’t bought yet, the answer is B, but if he did (at $8), then the answer is A. Same **** as this question. The question should have specified that the position has not yet been taken. I lost a lot of time reflecting on this ****.