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Siddharth Jha
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Intermediate
Asked: 2023-09-20T14:29:22+05:30 In:

Currency chapter

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Why have both of these same type of questions used different values in the solution?

In one of them they have used one year later’s spot rate and in one they have used the current spot to multiply with the interest rate.

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    1 Answer

    1. AnkitAgr
      Pro

      Let’s break down these differences:

      1. Arbitrage Opportunity in Currency Trading:
        • In the first question, the arbitrage opportunity involves buying one currency (BEL) in the interbank market and selling another currency (BRL) to a dealer.
        • The profit calculation is straightforward: It subtracts the buying rate of BEL from the selling rate of BRL.
        • This is a basic arbitrage scenario where you take advantage of differences in exchange rates between the interbank market and a dealer.
      2. Carry Trade Involving Currency Borrowing and Lending:
        • In the second question, it’s discussing a carry trade strategy that involves borrowing in one currency (USD) to invest in another currency (EUR).
        • The calculation here is more complex as it considers both exchange rate movements and borrowing costs.
        • To calculate the return on the unhedged EUR MRR deposit, it uses the exchange rates today and one year later to determine the investment’s return in USD.
        • Then, it subtracts the borrowing cost (one-year USD MER, which is 0.80%) from the return to get the net return on the carry trade.

      The reason for the differences in calculation methods is that these are two distinct concepts:

      • The first scenario is a simple arbitrage opportunity, which doesn’t involve borrowing or lending but instead takes advantage of pricing discrepancies in the market at a single point in time.
      • The second scenario is a carry trade, which is a longer-term strategy involving borrowing and lending in different currencies and accounting for exchange rate changes and borrowing costs over time.

      These differences in approach are due to the different nature of the scenarios and what they aim to illustrate. The second question is more complex because it simulates a carry trade strategy, which is inherently more involved than a basic arbitrage opportunity.

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