Risk of the Carry Trade The risk of the carry trade is that exchange rates may

move opposite to what the investors expected, which would cause a loss. Just as financial

leverage can magnify gains from a carry trade, it can also magnify losses from a carry

trade when the currency that was borrowed appreciates against the investment currency.

This dynamic is illustrated in the following example.

EXAMPLE Assume the same conditions as in the previous example but with one adjustment. Namely, suppose

the euro appreciated by 3 percent over the month against both the pound and the dollar; this

means that, at the end of the investment period, the euro is worth $1.236 and a pound is worth

1.456 euros. Under these conditions, Hamptons profit from its carry trade is measured below. The

changes from the previous example are highlighted below:

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. Hamptons total investment in pounds:

55,555 pounds 400,000 pounds 455,555 pounds

At End of Investment Period

4. Hampton receives:

455,555 _ 1.01 460,110 pounds

5. Hampton repays loan in euros:

600,000 euros _ 1.005 = 603,000 euros