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I am curious as to how someone performs a carry trade using forward contracts.

I've read that you go long on the currency that has the higher interest rate but this confuses me. In particular, I've read you take

  • an "uncovered forward position in the high interest rate currencies" source

  • a "long forward position in the high-interest curency using deliverable forex swaps" source

How do the mechanics of this work? You're borrowing in the currency that has the low IR and lending/accruing interest in the high interest currency with the intention of paying back the loan at maturity (i.e. purchasing the low interest security), so I'm very confused.

Any help in understanding this would be massively appreciated as neither of these resources does any type of job explaining how this works.

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The carry trade is a much simpler process than this makes out and doesn't require FX futures or swaps. Essentially you borrow an amount of money (from the bank, by issuing bonds etc. doesn't matter really) at a low interest rate in one currency, convert the borrowed money to a higher interest rate currency and lend it back out at that rate. After the loan time the borrower pays you back in their country's currency which you convert back into the other currency to pay off the loan you took out. Your profit is the difference.

The problem with doing this is that when the money that you have lent out is repaid it is repaid in the higher interest rate currency but you owe the money in the other currency. This exposes you to FX risk on top of the interest rate risk that you are bearing which you want to mitigate as much as possible. To do so you can lock in the exchange rate for the time when the principal of the loan is to be repaid to you with an FX future or forward for the same underlying currency pair. Since you know when you want to convert the money in the first place an FX swap, which locks in the FX rate for each "leg" - i.e. each time you do an FX conversion, is ideal.

With a locked in future interest rate you forgo the chance that the FX rate will move in your favour for a guaranteed rate in the future. The above analysis is based on zero coupon bonds but extends trivially to coupon bearing bonds - you just have two known cash flows in two currencies at regular intervals so can add futures or swaps to lock in the FX rate at those junctures.

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  • Even simpler, you don't even need to "lend" the money, you could even just deposit it into an interest-bearing bank account.
    – user68318
    Jul 28, 2023 at 16:34
  • @user68318 putting the money into an interest bearing account is lending it but its not the only way of lending it
    – MD-Tech
    Jul 31, 2023 at 8:06
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The carry trade is based on the idea (empirical observation) that frequently higher yielding currencies do not depreciate as much as (un)covered interest parity suggests. Therefore, you gain in the transaction.

With a forward, there is only one product / trade involved and if spot at the expiry date of the forward did not depreciate as much, you have your carry trade gain.

If you were to borrow in the low interest country, convert the proceeds into the high yield currency and invest there, but use a forward to lock in the FX rate, you have a zero sum game. The whole idea of the carry trade is to not do that because the forward price is exactly offsetting the interest rate difference. This is called Covered Interest Parity (CIP).

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No matter what you do, returns from investing domestically are equal to the returns from investing abroad. The FX forward you enter fixes that rate that guarantees no arbitrage.

The problem with borrowing in a currency, converting the proceeds at spot, investing in the high yielding currency and converting back are quite obvious. As a (retail) investor, you:

  • never borrow at a risk free rate (you will pay more),
  • you face fees for converting currencies, and
  • you usually earn less than the risk free rate when you deposit your money.

However, a forward will directly allow you to do all these steps in one packaged product, at rates that are very close to what the interbank market will be able to do.

You can read a lot more details in this econ stack exchange answer. As a word of caution; traders have a saying that:"

With the carry trade you go up the stairs and down the elevator".

There is a general tendency for the spot rate of the high yielding currency to depreciate. It may not happen for a while and your carry trade is profitable. However, it can often only take a few days or hours for all your gains to vanish if the spot market starts to move.

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