The authors describe an application of uncovered interest arbitrage (UIA) known as "yen carry trade." Define UIA and describe the example of yen carry trade
Why would an investor engage in the practice of yen carry trade and is there any risk of loss or lesser profit from this investment strategy?
What will be an ideal response?
Answer: UIA is the practice of investors borrowing money in countries where interest rates are relatively low, converting the loan proceeds into a currency where rates are relatively high, investing at the higher rate, subsequently converting the proceeds back into the original currency to repay the proceeds from the loan and hopefully realizing a greater return from this practice than if the borrowing and investing had all taken place in the original currency. The arbitrage is uncovered because at the time of the investment the investor does not lock in a forward exchange rate and therefore bears the risk that currency exchange rates will change in an unfavorable manner. The yen carry trade exists because rates in Japan are so very low that investors borrow yen, convert to another currency, say U.S. dollars, invest at much higher interest rates, often in default-risk free Treasury securities, then convert back to yen, repay the original loan and walk away with a significantly greater return than otherwise available. The risk in this process is neither from the investment nor from the loan. The risk is that exchange rates may change unfavorably and the investor takes a loss rather than a profit.
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