Suppose a US-based investor could earn 2.0% on a risk-free dollar denominated in
ID: 2727847 • Letter: S
Question
Suppose a US-based investor could earn 2.0% on a risk-free dollar denominated investment. A similar investment denominated in Bulgarian Lev (BGN) could earn 12.5%. Suppose there are no suitable derivatives to hedge exchange rate risk, so the investor is exposed to the risk that the Bulgarian Lav will depreciate to the dollar over the investment period. Assume a 1-year investment, what is the maximum percentage depreciation of the Lev against the dollar that would still allow the US investor to engage in the Carry Trade successfully?Explanation / Answer
Interest rate in USA = 2%
Interest rate in Bulgaria = 12.5%
Suppose investment value = $100,000
If investor invest in USA then value of investment after one year is calculated below:
Vale of investment = $100,000 × (1 + 2%)
= $102,000
If investor invest in USA then value of investment after one year is $102,000.
Again suppose current exchange rate is Lev 1 = $1
So after exchange of $100,000 the investor will get lev 100,000.
If investor invest in Bulgaria then value of investment after one year is calculated below:
Vale of investment = lev 100,000 × (1 + 12.5%)
= lev 112,500
If investor invest in Bulgaria then value of investment after one year is $112,500.
Now maximum depreciation of lev so that the investment is still considerable is the exchange rate at which the value of investment after one year will be same.
So exchange rate after one year = $102,000 / 112.500
= 0.90667
So percentage change in exchange rate = (1 – 0.90667) / 1
= 9.33%
Hence, maximum percentage depreciation of lev so that the investment is still considerable is 9.33%.
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