Question

Assume that you start by borrowing either $1 million or 120 million yen. Using a starting yen per dollar exchange of 120 yen per dollar and a one year US interest rate of 6% and 1 year Japanese interest rate of 1% . Explain how a hedge fund can use the carry trade to make profits or incur losses. In your answer show the profits or losses in both dollars and yen in the following three cases.

a. The exchange rate stays the same

b. The exchange rate moves to 140 yen per dollar

c. The exchange rate moves to 100 yen per dollar.

Answer 1

A hedge fund will make a profit by using the difference in interest rates
In case the exchange rate moves favourably , there will be more profit							and adversely a loss
	No	column	F	G
	row					calculations
			$	yen
a)	7	beginning balance	1	120		1	120
	8	ending balance	1.06			1*1.06
	9	amount owed	1.01	121.2		G9/120	G7*1.01
	10	profit	0.05	6	millions	0.05	F10*120
	11
b)	12	beginning balance	1	120		1	120
	13	ending balance	1.06			1*1.06
	14	amount owed	0.865714	121.2		G14/140	G12*1.01
	15	profit	0.19	26.6	millions	ROUND(F13-F14,2)	F15*140
	16
c)	17	beginning balance	1	120		1	120
	18	ending balance	1.06			1*1.06
	19	amount owed	1.212	121.2		G19/100	G17*1.01
	20	loss	-0.15	-15	millions	ROUND(F18-F19,2)	F20*100