Question

In: Finance

5. Suppose you could borrow at 0.5% in EUR and earn 6% in Brazil (both for...

5. Suppose you could borrow at 0.5% in EUR and earn 6% in Brazil (both for one year). Suppose also the current exchange rate is EURBRL 5.00. Finally, you are fairly certain the EUR will not spike in value too much over the coming months/years.

a. You will execute a carry trade. What three things do you do today? You have a credit line at Deutsche Bank of €20,000,000.

b. Suppose the rate in one year is (1) EURBRL 4.85 and (2) EURBRL 5.45. What profit/loss did you realize?

NOTE: be careful with the form of the exchange rates. In the example, we borrowed in JPY (the second currency of AUDJPY). In this problem, we borrow EUR (the first currency of EURBRL).

Solutions

Expert Solution

a) 3 Things to do Today
1) Borrow €20,000,000 @ 0.5%.
2) Convert the borrowed amount at Current Spot Rate EURBRL 5.00
Amount Received = €20,000,000*BRL5 = BRL100,000,000
3) Invest BRL100,000,000 @ 6%.
b) After 1 Year Rate is EURBRL 4.85
Investment Amount Received after 1 Year
= Amount Invested*(1+Lending Rate)
= BRL100,000,000*(1+6%)
= BRL100,000,000*(1.06)
= BRL106,000,000
Convert Investment in € at Rate after 1 Year
= Investment after 1 Year / Rate after 1 Year
= BRL106,000,000 / 4.85
= €21,855,670.10
Borrowed Amount to be repaid after 1 Year
= Borrowed Amount*(1+Borrowing Rate)
= €20,000,000*(1+0.5%)
= €20,000,000*(1+0.005)
= €20,100,000
Profit
= Amount of Investment after 1 Year - Borrowed Amount after 1 Year
= €21,855,670.10 - €20,100,000
= €1,755,670.10
After 1 Year Rate is EURBRL 5.45
Investment Amount Received after 1 Year
= Amount Invested*(1+Lending Rate)
= BRL100,000,000*(1+6%)
= BRL100,000,000*(1.06)
= BRL106,000,000
Convert Investment in € at Rate after 1 Year
= Investment after 1 Year / Rate after 1 Year
= BRL106,000,000 / 5.45
= €19,449,541.28
Borrowed Amount to be repaid after 1 Year
= Borrowed Amount*(1+Borrowing Rate)
= €20,000,000*(1+0.5%)
= €20,000,000*(1+0.005)
= €20,100,000
Loss
= Amount of Investment after 1 Year - Borrowed Amount after 1 Year
= €19,449,541.28 - €20,100,000
= -€650,458.72

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