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

Answer 1

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Answer:

At beginning of investment period:
1. Hampton invests $100,000 of its own funds into British pounds:
$100,000/($1.80 per pound) = 55,555 pounds
2. Hampton borrows 600,000 euros and converts them into British pounds:
600,000 euros/(1.5 euros per pound) = 400,000 pounds
3. Hampton's total investment in pounds:
55,555 pounds + 400,000 pounds = 455,555 pounds

At end of investment period
4. Hampton receives:
455,555 x 1.01 = 460,110 pounds
5. Hampton repays loan in euros:
600,000 euros x 1.005 = 603,000 euros
6. Amount of pounds Hampton needs to repay loan in euros:
603,000 euros / (1.5 euros per pound) = 402,000 pounds
7. Amount of pounds Hampton has after repaying loan:
460,110 pounds - 402,000 pounds = 58,110 pounds
8. Hampton converts pounds held into U.S. dollars:
58,110 pounds x $1.80 per pound = $104,598
9. Hampton's profit:
$104,598 - $100,000 =$4,598

The profit of $4,598 to Hampton as a percentage of its own funds used in this carry trade strategy over a 1-month period is:
$4,598/$100,000 = 4.598 percent