Question

1. The currency of the European Union is the Euro (€). Consider a 2.0% annual interest rate in the United States, 0.0% interest rate from the European Central Bank (ECB), a spot exchange rate of 1.117 $ per €, and a futures exchange rate for 1.140 $ per € for delivery 12 months from now.

If you were to take $1,000,000 from the U.S. and deposit in a European bank for one year, you would be able to conduct the covered carry trade and earn a risk-free return in excess of $1,000.

TRUE or FALSE

2. If you believe interest rates will rise and you want to make a speculative futures trade to profit off this expectation, you should go LONG futures.

TRUE or FALSE

Answer 1

Let us first understand the meaning of Interest Rate :- An interest rate is defined as the proportion of an amount loaned which a lender charges as interest to the borrower. It is usually expressed as an annual percentage. It is the rate a bank or other lender charges to borrow its money or the rate a bank pays its savers for keeping money in an account. Now let us understand the meaning of Currency Carry Trade :- A currency carry trade is a strategy where a high yielding currency trades with a low yielding currency. A trader using this strategy attempts to capture the difference between the rates which can often be substantial depending on the amount of leverage used. And at last let us understand the meaning of Risk Free Return :- Risk free return is the theoretical return attributed to an investment that provides a guaranteed return with zero risks. In simple words the risk free rate of return represents the interest on an investors money that would be expected from an absolutely risk free investment over a specified period of time. The answer with explanations of questions asked above are as follows : The answer of the first question is (False) because as we know from currency carry trade defination that according to this strategy higher yielding currency trade with lower yielding curreny which means that when we will take €1,000,000 from European Union and deposit it in United States bank for one year then we will be able to conduct the covered carry trade and earn a risk free return. We cannot earn profit by depositing $1,000,000 to European bank for one year because dollar is lower yielding currency as compared to Euro and the interest rate of ECB is also 0.00 . The answer of the second question is (True) because if interest rates rise in the future the value of the future will fall (as it is linked to the underlying asset and bond prices) and hence a profit can be made when closing out of the future.