Forex Carry Trades: Interest Differentials, Parity, and Risk
Summary
A forex carry trade seeks to earn the interest-rate difference between currencies by holding a position that receives the higher rate and pays the lower one. The document explains how that return depends on the position and notional, and introduces covered and uncovered interest rate parity. It emphasizes that parity is an expectation about exchange rates, so an interest differential does not guarantee arbitrage profits in practice.
The discussion describes risks that can erase the interest earned: central bank rate changes, interventions that move exchange rates, and leverage that magnifies losses. It cites the 2008 financial crisis and sharp yen moves as examples of how currency losses can overwhelm carry returns, and suggests considering currency risk, timing, and stop losses. The article gives a dated interest-rate example and general guidance favoring more established currencies for newer traders, but does not provide a tested entry, exit, or position-sizing system. Its examples are historical and should not be treated as current market data.
Key ideas
- A carry trade aims to earn the interest-rate difference between two currencies.
- Exchange-rate moves can overwhelm the interest earned, especially during market stress.
- Interest rate parity relates interest differentials to spot and forward exchange rates, but the document distinguishes forecasts from realized outcomes.
- Changing central bank rates and currency interventions can alter a trade’s return.
- Leverage magnifies losses, so carry positions require careful risk management.
Tags
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.