Question

Hampton Investment Co. is a U.S. firm that executes a carry trade in which it borrows euros (where interest rates are presently low) and invests in British pounds (where interest rates are presently high).

Hampton uses $100,000 of its own funds and borrows an additional 600,000 euros and convert to British Pounds.

It will pay 0.5% interest on euros borrowed for the next month and will earn 1.0 % on funds invested in British pounds.

Assume that the euro’s spot rate is $1.20 and that the British pound’s spot rate is $1.80. The pound is worth 1.5 euros at this time.

Hampton uses today’s spot rate as its best guess of the spot rate one month from now.

Calculate Hampton’s expected profits from its carry trade. Fill the answers for questions A to J

At Beginning of Investment Period

A. Hampton invests $100,000 of its own funds into British pounds: Convert to British pounds

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B. Hampton borrows 600,000 euros - convert them into British pounds:

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C. Hampton’s total investment in pounds (A+B):

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At the End of Investment Period

D. Hampton's receipt from investment (amount from C + interest 1%):

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E. Hampton's repayment of loan (600,000 Euros) with interest (0.5%):

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F. Amount of pounds Hampton needs to repay loan in euros (Convert E into Pounds):

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G. Amount of pounds Hampton has after repaying loan (D-F):

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H. Hampton converts pounds held into U.S. dollars (Convert G into $):

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I. Hampton’s profit (H-$100,000):

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J. The above profit of Hampton as a percentage of its own funds used in this carry trade strategy over a one-month period is therefore I/$100,000

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Answer 1

The question is very specific in nature. Therefore, explanation has been provided as and where possible.

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At Beginning of Investment Period

Part A)

Hampton invests $100,000 of its own funds into British pounds:

Converted Value = Amount Invested in Dollar Value/British Pound’s Spot Rate = $100,000/$1.80 = 55,555 pounds

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Part B)

Hampton borrows 600,000 euros - convert them into British pounds:

Converted Value = Amount Borrowed/Euros Per Pound Rate = 600,000 euros/1.5 euros per pound = 400,000 pounds

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Part C)

Hampton’s total investment in pounds (A+B) = 55,555 pounds + 400,000 pounds = 455,555 pounds

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At the End of Investment Period

Part D)

Hampton's receipt from investment (amount from C + interest 1%) = 455,555 pounds + 455,555 pounds*1% = 460,110 pounds

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Part E)

Hampton's repayment of loan (600,000 Euros) with interest (0.5%):

Repayment Value = Loan Amount + Loan Amount*Interest Rate = 600,000 euros + 600,000 euros*0.5% = 603,000 euros

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Part F)

Amount of pounds Hampton needs to repay loan in euros (Convert E into Pounds):

Converted Value = 603,000 euros/1.5 euros per pound = 402,000 pounds

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Part G)

Amount of pounds Hampton has after repaying loan (D-F) = 460,110 pounds - 402,000 pounds = 58,110 pounds

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Part H)

Hampton converts pounds held into U.S. dollars (Convert G into $):

Converted Value = Amount of pounds Hampton has after repaying loan*British pound’s spot rate = 58,110 pounds*$1.80 per pound = $104,598

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Part I)

Hampton’s profit (H-$100,000) = $104,958 - $100,000 = $4,958

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Part J)

The above profit of Hampton as a percentage of its own funds used in this carry trade strategy over a one-month period is therefore I/$100,000 = $4,958/$100,000 = 4.958%