Currently in the London Interbank Market money center banks are offering to make 1 year loans to other money center banks at rate of 0.81% for loans denominated in GB Pounds and 1.4% for loans denominated in $.Assume that large institutional funds hedge funds or pension funds can either borrow or lend at these rates in the London interbank market. Moreover, assume that currently the exchange rate of the GBP is $1.31/1 GBP.
a. According to the interest rate parity condition what is the breakeven exchange rate of the GBP in terms of dollars 1 year from now?
b. Recent reports have mentioned the possibility that investors with an appetite for risk might want to engage in a "carry trade" involving ponds and dollars. Explain what a US hedge fund manager who had $100 million to invest in setting up a carry trade would do and how much his/her net profit would be after a year if the exchange rate of the pound in terms of $ remained at $131. (Note: assume here that the relevant possible investment strategies are simply to either invest in 1 yr $ deposits in the London Interbank market or to invest in 1 yr pound deposits in the London interbank market. You need not worry about strategies involving use of leverages.)
c. Why is the carry trade considered a "risky" strategy? Be explicit. What directional move of the $/GBP exchange rate over the year would threaten the carry trader with large % losses?