FX Carry Trade, Forward Pricing, and Uncovered Interest Parity
Summary
The document distinguishes an unhedged foreign exchange carry trade from a forward trade that locks in an exchange rate. Carry involves borrowing the lower-interest-rate currency and holding the higher-interest-rate currency, leaving the investor exposed to future spot movements. The interest-rate differential may be earned if exchange rates remain stable, but currency depreciation can offset or exceed it.
Covered forward pricing incorporates the interest-rate differential, so hedging the currency exposure removes the apparent risk-free gain under no-arbitrage pricing. The answers connect the intuition that exchange rates should adjust to uncovered interest parity (UIP), which treats the forward rate as an unbiased predictor of future spot. They note that empirical findings have challenged UIP: high-rate currencies have historically depreciated less than it predicts on average. That observation is not a guarantee of profit; carry returns remain uncertain, and the text supplies no risk-adjusted performance analysis or implementation details.
Key ideas
- An unhedged FX carry trade earns the interest differential while remaining exposed to spot exchange-rate risk.
- A currency move against the position can erase the interest earned or produce a loss.
- Forward rates reflect the interest-rate differential under covered no-arbitrage pricing.
- Uncovered interest parity predicts exchange-rate adjustment but has limited empirical support as a reliable forecast.
- Historical carry returns do not guarantee future profitability.
Tags
Full text
# Simple question about FX carry trade # Simple question about FX carry trade I have been reading online about the FX carry trade and how this can be profitable (in general). From my understanding, the idea is to be long (lend) the currency with higher interest rate and short (borrow) the currency with lower interest rate. This is effectively borrowing at the lower rate and lending at the higher one. However, say that 1 NZD = 1USD today. If yearly interest rates are 10% in NZ and 1% in US, then doesnt that mean that 1 year from now, 1.1 NZD = 1.01 USD so it takes more NZD than before to purchase a single dollar? ## Answer by mbison (score 1) https://quant.stackexchange.com/a/20790 If you would want to lock in a Forward USDNZD rate then both the 10% and 1% are taken into account like you suggested. But if you would enter the fx carry trade like you suggested without trying to lock in a forward rate. Then the spot rate 1 year from now is still a random variable from todays perspective. You might get lucky and the rate does not change, giving you a 9% (10 -1) rate differential. You might get even luckier and the fx spot moves in your favour. Or you might get unlucky. But as said earlier, if you want to remove this randomness of the fx spot by entering into a Fwd you will give up all your interest rate gains as there is no free lunch. ## Answer by nbbo2 (score 1) https://quant.stackexchange.com/a/20792 You wrote "doesnt that mean that 1 year from now, 1.1 NZD = 1.01 USD". This is true if the UIP (Uncovered Interest Parity) is true, or in other words if the forward rate is an unbiased predictor of the future exchange. However empirical research has cast doubts on this theoretical proposition. It seems, for reasons that are not entirely clear yet, that high interest rate currencies on average depreciate less than your statement indicates, making the carry trade on average profitable over long historical periods. [As mbison points out sometimes you lose and sometimes you gain]. A good overview article (though somewhat old) is Froot K.A. and Thaler R.H., 1990.“Foreign Exchange,” Journal of Economic Perspectives,vol 4.pp.179-192.
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