How do you calculate carry trades?

CFA Level II Economics
#1

Can someone explain pls? Thanks

#2

  1. What is carry trade: you borrow in low yield currency and invest in high yield currency (you sell your low yield currency to buy high yield currency).

  2. Calculation: [(Notional in Investing currency using initial FX rate * (1+yield in investing currency)) * FX Rate to turn the investing notional into borrowing currency using expected spot rate] - Yield in borrowing currency * Notional in borrowing currency

  3. If you want to close your carry trade position: sell investing currency and buy borrowing currency

  4. Reasons for closing carry trade position: volatility filters being breached, or valuation filters being breached (investing currency becomes overvalued (= lower yield) or borrowing currency becomes undervalued = higher yield).

#3

Great summary! I’ll be using this :slight_smile:

#4

Can anybody please check where my calculations are wrong? The data is from CFAI mock PM Q24. They’ve stated “Using the data … for the interbank only” so I decided to calculate carry trade only for EUR / USD

Start with 100,000 euro, sell euro to buy USD => 100,000/ 0.8065 = $ 123,992.56

After 1 year receive 0.9% => 123,992.56 * 1.009 = $ 125,108.49

Convert to euro : $125,108.49 * 0.82 = 102,588.96

Repay 0.8% and receive net gain: 102,588.96 - 100,800 = 1,788.96 euro

The solution in the answer is to buy DRN and to receive 1,065 euro which is less.

I thought I know how to calculate carry trade and now this is bugging me.

#5

Funding ccy = EUR, investing CCY = DRN.

So you translate 100,000€ into DRN using the bid-rates (you sell Euros to buy DRN) = 100,000 * DRN/USD * USD/EUR = 100,000 * (1/0.8065) * 1.2050 = 149,411 DRN

You multiply this amount by (1 + yield in DRN).

You convert the latter into Euros using the future spot rate EUR/DRN (i.e. EUR/USD * USD/DRN).

You substract the latter by (Yield in € * 100,000€).

It’ll give you 1,065.

You should use DRN instead of USD, since DRN has a higher yield than USD.

#6

^nothing wrong with your calculation. I find the question and its answer wierd because we would gain more with the EUR-USD pair. @OP: You borrow in a low yield currency and invest in a high yield currency For example: 1. You borrow 100 USD at x% interest for one year. After one year you have to return the amount of 100*(1+x%) . So you want to invest the borrowed money somewhere so that you can have more than 100*(1+x%) USD , right? 2. You sell that 100 USD to buy , for example, 90 EUR. You put those euros into a bank for one year to earn %y interest. After one year, you withdraw and get 90*(1+y%) EUR 3. Then you sell 90*(1+y%) EUR to buy USD. 4. You use the USD in (3) to pay your borrowing in (1) (i.e 100*(1+x%)). The difference is your profit.

#7

Thank you, Gurifissu. For the exam I’ll go straight for the currency with the higher rate. For this concrete vignette I still can’t understand why the profit will be higher if we use only EUR/USD and why the correct answer isn’t 1,788.96.

#8

Yes!! That CFAI mock exam question exactly. There’s a question in the CFA textbook and the calculation is done differently. It’s confusing.

#9

Just went through the same dillema!!

The mock exams this year were poorly done IMO. I still scored ~73%.

#10

TheLakeHouse , I saw your answer just now (yeh, I know it’s two days later, I lack sleep). Thank you for the reply, I thought I have some general misunderstanding of carry trade.

MrSmart , the mock exam was quite poor indeed, there were several fundamental mistakes. The worse thing is that the actual exam can be of the same quality.

#11

I missed the carry trade question as well. I looked at it and saw that the interbank rows only had 2 currency rates and the other rate was in the dealer row of the table… didn’t think the really high yield was fair game because of their wording…

#12

@Gebura: what I find wierd about the question is that they tell us to “use the interbank section in exhibit 2”. I don’t remember the exact wording but this was misleading.

#13

This is exactly what I’m referring to in my post one above yours. I think it was pretty poorly worded…

#14

^… yes

It is funny that while I was working on USD/DRN, I found out they told us to use info from interbank rows and I was thinking “oops, I was almost trapped” then switched to do calculations with the pair US-EUR … laugh

#15

I’m not band-wagoning here, but I started that calculation too haha… Clearly, we know what to do, but the question was suspect. Hopefully, the real exam doesn’t have as many issues as this mock or the online assessments. It seems like LII material has more errors, or is that just me?

#16

Same. Ignored DRN altogether because of its placement in the dealer row. I have quite a few issues with the official mock and that was definitely one of them.