Assumptions : 5.5% for one-year sterling deposits and 5% for US dollar deposits over the same period , the spread between them is 0.5%. Assuming that the current exchange rate between them is 1 pound = 1.5 US dollars, then if the exchange rate fluctuations are not considered, the sum of the principal and interest of a one-year deposit of 1,500 US dollars is 1,575 US dollars (1,500 US dollars × (1+5%) ) , converted to GBP 1050 ($1575 ÷ $1.5). However, if the 1,500 US dollars are first converted into 1,000 pounds, the sum of the principal and interest for the previous year will be 1,055 pounds [1,000 pounds × (1+5.5%)].
In short, there is a 0.5% spread for the same amount of deposits in GBP versus USD. But this can only be achieved when the exchange rate remains unchanged. In other words, if the exchange rate fluctuation between them is 1 pound = 1.48 dollars when the one-year deposit expires, the sum of the principal and interest of 1,055 pounds deposited in sterling is converted into USD 1,561.4 (1,055 pounds × 1.48 dollars), On the contrary, it is 13.6 US dollars less than the US dollar deposit (1575 US dollars – 1561.4 US dollars), which is because the exchange rate difference between the British pound and the US dollar reaches 1.33% in one year (1.50 US dollars – 1.48 US dollars) / 1.50 US dollars ].
Therefore, when the exchange rate difference is greater than the interest rate difference, the carry trade is not worth the loss. In fact, due to the relationship between supply and demand, in the foreign exchange market , the forward exchange rate of currencies with high interest rates will indeed decline, and the situation that the exchange rate difference is greater than the interest rate spread does exist. Therefore, in the arbitrage transaction, the factors of exchange rate difference and interest rate difference must be integrated. Just think about it. Of course, if there is a forward foreign exchange market, people can use the swap method to avoid the risk of the above exchange rate fluctuations and earn interest margins. This practice is called offset arbitrage.
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