Can someone explain the last part of this question? Just the part i have bolded about the final return.
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It should read:
1 / 127.93 × (1 + 0.0140) × 129.96] − [1.000 × (1 + 0.0015)] = 1.0301 − 1.0015 = 2.86%
Why is it 1/127.93?
You borrow ¥1 and convert it to €0.007817 (0.007817 = 1/127.93).
I think I am going about these problems wrong. How would you tackle the below problem? Thanks!
Currency Pair** Bid (spot)****Offer (spot)****Projected Spot in one year **One-Year Libor Rates Interbank Market: EUR/USD 0.8045 0.8065 0.8200 EUR 0.8% DNR/USD 1.2050 1.2100 1.2280 USD 0.9% Daltonian Dealer: DNR/EUR 1.5140 1.5190 DNR 3.0%
Q. Using the data provided in Exhibit 2 for the interbank market only, a European investor who attempts to exploit the DNR currency market with a normal one-year carry trade based on a 100,000 EUR position will most likely achieve a net profit in EUR of:
- 1,963.
- 3,018.
- 2,218.
Borrow EUR100,000 @ 0.8% per year. Convert that to DNR149,411 (= 100,000 / 0.8065 × 1.2050), and invest it @ 3.0% per year.
In one year, you have DNR153,893 (= 149,411 × 1.03). Convert that to EUR102,763 (= 153,893 / 1.2280 × 0.8200). Pay off the loan of EUR100,800 (= 100,000 × 1.008). The profit is EUR1,963 (= 102,763 − 100,800).
I want to make sure I understand the two examples correctly. In the first step we want to convert our currency:
- In example one we borrow JPY (foreign) and buy EUR (domestic). I notice that we divide by the cross spot rate of 127.932.
- In example two we borrow EUR (domestic) and buy DNR (foreign). I notice here that we multiply the 100,000EUR by the cross spot rate of 1.4941 (= 1/.8065 * 1.205)
Is this because in example one we are holding JPY (the foreign currency) and in example two we are holding EUR (the domestic currency) or is this because when you buy the foreign currency you always multiply (or divide when you buy the domestic)? Hope the question isn’t too convoluted and can be answered. I feel like this is the only piece missing in my understanding of the carry trade calculation.
You shouldn’t think of foreign and domestic; it doesn’t matter which is your home currency (or for that matter, whether either even is your home currency).
What matters is that you borrow the currency with the low interest rate and exchange it for the currency with the high interest rate.
As for multiplying or dividing by the cross rate, it depends on how the rate is quoted. If you have EUR and you want JPY, then you’ll multiply by the JPY/EUR rate, but you’ll divide by the EUR/JPY rate.
This now makes perfect sense to me. Thanks so much S2000magician!
My pleasure.
So in example one we want to buy EUR and are given JPY/EUR - so we divide by the cross rate. In example two we want to buy DNR and are given DNR/EUR - so we multiply by the cross rate. Fantastic. Thank you so much.
It’s easier (for me) to figure out if I think of the quotes as actual fractions - when I wonder which quote to use, I first think of which currency I need to end up with, and then select the quote. For example. If I have 1000 EUR and the EUR/USD quote is 0.6, while the USD/EUR quote is 1.67, I think about which one of the two I need multiply or divide to buy USDs. Well, 1000 EUR * 0.6 EUR/USD would make 600 EUR2/USD currency units, a financial nonsense. So obviously I need to divide instead, that way I get 1000 EUR / 0.6 EUR/USD, which is equivalent to 1000 EUR * 1.67 USD/EUR (dividing is equivalent to multiplying the reciprocal of the fraction). Then, I get 1670 EUR*USD/EUR (the euros cancel each other in the numerator and denominator) and I end up with 1,670 USD.
You’ve been reading my articles.
How do we figure out that we have to divide 100,000 by 0.8065 and multiply by 1.2050 and also in the second part 153,893 divided by 1.228 and multiplied by 0.82.
Read what Nenorr wrote.
To get from EUR to DNR you have to multiply by USD/EUR, then multiply by DNR/USD. We aren’t given USD/EUR; we’re given EUR/USD, so you divide by EUR/USD.
Magician why are we using USD/EUR offer rate and DNR/USD Bid rate.
Dealers are cheapskates: you’ll always end up with the lower amount of the new currency.
If you multiply, multiply by the smaller number. If you divide, divide by the larger number.
0.8065 > 0.8045, and we’re dividing: divide by 0.8065.
1.2050 < 1.2100, and we’re multiplying: multiply by 1.2050.