Currency carry trade involves buying a high-yielding currency and funding it with a low-yielding currency, without any
Question:
Currency carry trade involves buying a high-yielding currency and funding it with a low-yielding currency, without any hedging. Generally, Chinese Yuan and Swiss Franc have been popular funding currencies for the carry trade (due to the low interest rate in these countries), while British Pound and Australian Dollar have been popular investment currencies due to their high interest rates. Say currently, 1 Australian Dollar (AUD) is equivalent to 84.25 Chinese Yuan (CNY), the interest rate in Australia is 0.1% , and the interest rate in China is -0.1%. You decide to borrow CNY and invest in AUD for a year, and consider transaction costs to be nil.
a. What must be the expected exchange rate (AUD/CNY) for the carry trade to be profitable?
b. Half a year after you have initialized your carry trade, Australia announces that they will cut interest rates. How are these rate cuts going to hamper/benefit your trading strategy?
c. Instead of investing in AUD for a year and exchanging it back to yen at the spot rate at that time, you venture into a forward deal with the forward exchange rate being 83 AUD/CNY (assume that this forward exchange rate is the fair/correct price). Comment on the riskiness of the Chinese Bond Market.
d. Explain when the currency carry trade strategy fails to be profitable, and should investors go for such strategies during times of volatility?
