Carry Trade Strategy)In Jan 2003, the interest rate on Japanese Yen was 0.5% and on Australia dollar was 6%. The spot rate was S(¥/AU$)=69.28. Tom Bohn, a hedge fund trader specializing in FX trading in Blackrock Inc, started a carry trade between Yen and Australia for one year. a. Compute the carry between Yen and AU$. Which currency was the funding currency? Target currency? b. If the spot rate was S(¥/AU$)=79.56 at the end of the year, compute the profit on the carry trade if Tom was able to borrow ¥100m or equivalent AU$. c. At what spot rate Tom would break even? d. What would be the market forward price in Jan 2003? e. If Tom was unable to borrow any currency, but was able to trade FX forwards and spots, what was the realistic alternative strategy for the carry trade?
I'm not sure where to start
To answer the questions related to the carry trade strategy, let's break down the different components and calculations involved:
a. Compute the carry between Yen and AU$:
The carry trade involves borrowing in a low-interest rate currency (funding currency) and investing in a high-interest rate currency (target currency). In this case, since the interest rate on Yen is 0.5% and on AU$ is 6%, Yen is the funding currency and AU$ is the target currency.
To calculate the carry, we subtract the interest rate on the funding currency from the interest rate on the target currency:
Carry = Interest rate on the target currency - Interest rate on the funding currency
Carry = 6% - 0.5% = 5.5%
b. Computing the profit on the carry trade:
If Tom borrowed ¥100 million or the equivalent in AU$ at the start, he would have to convert it to AU$. Using the spot rate of S(¥/AU$) = 69.28, Tom would have received:
¥100 million / 69.28 = AU$1,441,436.46
At the end of the year, if the spot rate became S(¥/AU$) = 79.56, Tom would convert the AU$ back to Yen:
AU$1,441,436.46 * 79.56 = ¥114,752,117.48
The profit on the carry trade would be the difference between the amount of Yen borrowed and the amount obtained after converting back:
Profit = Amount obtained - Amount borrowed
Profit = ¥114,752,117.48 - ¥100,000,000 = ¥14,752,117.48
c. Calculating the break-even spot rate:
The break-even spot rate is the point at which the profit from the carry trade becomes zero. To calculate this, we need to consider the interest rate differential and the initial spot rate.
Break-even spot rate = Initial spot rate * (1 + Interest rate on funding currency) / (1 + Interest rate on target currency)
Break-even spot rate = 69.28 * (1 + 0.005) / (1 + 0.06)
Solving this equation would give you the break-even spot rate.
d. Computing the market forward price in Jan 2003:
The market forward price is determined by interest rate differentials between the two currencies and market expectations. Unfortunately, since the information provided does not include the interest rate differentials between Yen and AU$, we don't have enough data to calculate the market forward price.
e. Realistic alternative strategy without borrowing:
If Tom was unable to borrow any currency but could trade FX forwards and spots, a realistic alternative strategy for the carry trade would be to use a synthetic carry trade. This involves using FX forwards to create exposure to the interest rate differential.
Tom could enter into a forward contract to buy AU$ in the future, based on the current spot rate and the expected future spot rate, to take advantage of the interest rate differential. By using the forward contract, he can still benefit from the carry trade without the need for borrowing.