How FX Carry Is Earned and What Hedging Changes
Summary
The document explains how a currency investor can receive the higher interest rate associated with a foreign currency. After exchanging domestic funds for foreign currency, an investor may hold the balance in a local bank account that pays interest, subject to the bank’s spread. A cross-currency swap offers another route, exchanging the currency exposure for a period while incorporating the FX basis and the interest rate on the currency received.
These are unhedged positions, so exchange-rate movements can outweigh the interest earned. Hedging the exposure with an FX forward removes the apparent rate advantage under covered interest parity. The response therefore distinguishes earning interest from making a profitable carry trade: access to deposit or swap markets can deliver the interest component, but the net result remains exposed to currency moves, transaction terms, and basis. The account is explanatory and gives no empirical performance evidence or detailed treatment of funding and counterparty constraints.
Key ideas
- An investor can earn foreign interest by holding currency in a remunerated local account.
- A cross-currency swap can exchange currency exposure while incorporating interest rates and FX basis.
- Unhedged carry remains exposed to exchange-rate changes that can offset interest income.
- An FX forward hedge removes the rate differential under covered interest parity.
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# Can you actually earn the carry return in FX? # Can you actually earn the carry return in FX? I know that carry is an important factor to value currency. However, it is not obvious to me how you can actually earn the carry return, and if as a pure currency investor, should not you be interested only in the spot return. For example, if country A has a 3m interest rate of 2% and country B has a 3m interest rate of 10%, assuming the exchange rate remains constant, you can earn 8% in 3m. However, if I just buy the currency of country B at the beginning of the period and I sell it at the end of the 3m, I have not earned anything. Thus, am I right assuming that the importance of carry is that it attracts investments in the currency of country B, pushes up its demand and thus makes just more likely that it will appreciate in the future? Or you can actually earn this 8% just buying the currency and holding it (I mean a bank of that country can just deposit the money at the central bank, but a foreign bank or a private investor cannot) ? ## Answer by Jan Stuller (score 2, accepted) https://quant.stackexchange.com/a/75306 Practically, if you have access to the financial markets, you can earn that interest. On day one, you sell your domestic currency denoted $X_d$ (where the 3m prevailing rates are 2%) and you buy the foreign currency $X_f$ (where 3m prevailing rates are 10%). If you leave this position unhedged, your foreign currency will be sitting in a Nostro account (see this wiki link for Nostro account explanation: basically, a Nostro account is a bank account in a foreign country, with a domestic bank in that country, which allows you to hold the local currency: so if you buy $X_f$, that money will be sitting in the Nostro account with a domestic bank in that country: and usually that bank will remunerate that balance with the prevailing rate (say 10%) minus some spread: so that's one way to earn the interest). (Btw, many people might not realize this, but when you buy a foreign currency, unless you bring it back to your country as paper bills, that currency will "physically" never leave the home country: it will always be sitting in some local Nostro account: that's how central banks control the supply of money, digitally, that money never leaves the domestic country, because only domestic licensed banks can hold the local currency digitally: that's how money works, a fascinating subject in itself). Another way to earn that interest is to use an XCCY-Swap: once you own the currency $X_f$, you can "swap" it out for 3 months in the financial markets using an XCCY-swap: then, you will earn the 10% rate plus or minus the prevailing FX basis and you will in exchange get a currency of your choice, on which you pay the prevailing interest rate in that currency plus or minus the prevailing FX basis. Note however, that all these positions described above are unhedged: you can lose a lot of money on the change in FX rates. If you wanted to hedge with an FX forward, the covered FX parity would ensure that you make no money on the trade.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.