Chartered Financial Analyst (CFA) Practice Exam Level 2

What does the Carry Trade strategy involve?

1. Investing in low-risk currencies to augment portfolio returns

2. Borrowing in lower-yielding currency to invest in higher-yielding currency

3. Using forward contracts to lock in investment returns

4. Assuming interest rate differentials will remain stable

The correct answer is: Borrowing in lower-yielding currency to invest in higher-yielding currency

The Carry Trade strategy primarily involves borrowing in a lower-yielding currency and investing the funds in a higher-yielding currency. This approach takes advantage of the interest rate differentials between two currencies. Investors can profit from the spread, gaining the interest differential as well as potential foreign exchange gains if the higher-yielding currency appreciates against the currency in which they borrowed. This strategy operates on the assumption that the interest rate differential will remain stable, allowing the investor to benefit from the ongoing income generated from the higher-yielding investment. It typically carries some risks, including fluctuations in exchange rates, which can affect the profitability of the trade. While the other options may touch upon related concepts, they do not accurately describe the carry trade itself. Using low-risk currencies for portfolio returns or forward contracts to lock in investment returns may be relevant to various investment strategies, but they do not capture the fundamental mechanics of the carry trade.