Practice Quiz 8 — Carry Trades & Hedging

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The spot rate is S = $/Yen = 0.0067 (1 USD = ~149 Yen). The US 1-year rate is 4.5% and the Japanese 1-year rate is 0.5%.

A hedge fund borrows 100 million Yen, converts to dollars, and invests in US Treasuries for one year.

(a) How many dollars does the fund receive today? How many Yen does the fund owe after one year (principal + interest)?

(b) Suppose the yen strengthens to S = $/Yen = 0.0075 (1 USD = ~133 Yen) over the year. Compute the fund’s dollar profit or loss on the trade. Did the carry trade work out?

(c) In 2–3 sentences, explain why carry trades tend to generate small steady profits most of the time but occasionally suffer large losses. How does this relate to what happened with the yen in July 2024?