How Is Carry Trade Return Calculated?

How Is Carry Trade Return Calculated?
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  1. Basically, in a carry trade you borrow a currency that has a low interest rate, then use that money to buy another currency that pays a higher interest rate. You make profit on the difference between the interest rates. So the steps to calculate this amount is firstly assume that a trader notices that rates in Japan are 0.25 percent, while they are 2 percent in the United States. This means the trader expects to profit 1.75 percent; the difference between the two rates. The first step is to borrow yen and convert them into dollars. The second step is to invest those dollars into a security paying the U.S. rate. Assume the current exchange rate is 230 yen per dollar and the trader borrows 100 million yen. Once converted, the amount that he would have is:
    U.S. dollars = 100 million yen ÷ 230 = $434,782.61
    After a year invested at the 2 percent U.S. rate, the trader has:
    Ending balance = $434,782.61 x 1.02 = $443,478.2622
    Now, the trader owes the 100 million yen principal plus 0.25 percent interest for a total of:
    Amount owed = 100 million yen x 1.0025 =100.25 million yen
    If the exchange rate stays the same over the course of the year and ends at 230, the amount owed in U.S. dollars is:
    Amount owed = 100.25 million yen ÷ 230 = $435, 869.5652
    The trader profits on the difference between the ending U.S. dollar balance and the amount owed, which is:
    Profit = $443,478.2622- $435, 869.5652 = $7,608.697
    Notice that this profit is exactly the expected amount: $7,608.697 ÷ $434,782.62 = 1.75%

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