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On FX Carry Trades

I present a framework for formulating a view on FX markets and a guide for thinking through the
forces that drive exchange rates. This aids an insightful analysis of the most popular currency strat
egy the FX carry trade.

International Parity Conditions


International parity conditions form the building blocks of most models of exchange rate determina
tion. The key international parity conditions are as follows:

1. Covered Interest Rate Parity


2. Uncovered Interest Rate Parity
3. Forward exchange rates as unbiased predictors of the future spot exchange rates
4. Purchasing power parity
5. The Fischer effect
6. The international Fischer effect;
7. Real interest rate parity

If these international parity conditions held at all times, moving capital from one market to another
would offer no profitable trading opportunities for FX traders. Most empirical studies find that the
key international parity conditions rarely hold in either the shortterm or medium term. The excep
tion is covered interest rate parity that is enforced by an executable arbitrage relationship. There
are often significant departures from uncovered interest rate parity, purchasing power parity and
real interest rate parity. In addition, forward exchange rates have been typically found to be poor
predictors of the future spot exchange rates.

Covered Interest Rate Parity(CIRP)


An investment in a fullyhedged(covered) foreign money market instrument should yield exactly
the same returns as an otherwise identical domestic money market instrument.

Given the spot exchange rate and the domestic and foreign yields, the forward exchange rate must
equal the rate that gives these two alternative investment strategies , exactly the same holding
period return.

I will work with the GBP/INR currency pair in the following example; GBP is the base(foreign)
currency and INR is price(domestic) currency. The spot GBP/INR exchange rate denoted as
SGBP/INR = 100.

1. One alternative is to invest 100 INR for one year at the domestic riskfree interest rate ( rINR ). At
the end of the year, the investment is worth 100(1+rd ). If we have SGBP/INR units of the domestic
currency, FV= SGBP/INR (1+rINR ).
2. The other alternative is to convert the SGBP/INR units of domestic currency to 1 foreign currency
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unit at the spot rate and invest for one year at the foreign riskfree rate ( rGBP ). At the end of the
period, the investor would have (1+rGBP ) units of foreign currency. These funds must then be con
verted back to the investors domestic currency at the then prevailing spot rate. If the exchange rate
to be used for this endofyear conversion is set at the startof the period using 1year GBP/INR
outright FX forward, then the investor would have eliminated any foreign exchange risk. Letting
FGBP/INR denote the forward rate, the investor would obtain (1+ rGBP )FGBP/INR units of domestic cur
rency.

Because each of these two investments are riskfree, they must have the same return.
SGBP/INR (1 + rINR ) = (1 + rGBP ) FGBP/INR
(1 + rINR )
FGBP/INR = SGBP/INR (1)
(1 + rGBP )
The daycount convention for most LIBOR deposits is Act/360. Incorporating this daycount conven
tion, the arbitrage formula becomes,
1 + rINR Act
360

FGBP/INR = SGBP/INR (2)
1 + rGBP Act
360

The CIRP equation can be rearranged to give the FX swap premium.


FGBP/INR - SGBP/INR Act
360

= (rINR - rGBP ) (3)
SGBP/INR 1 + rGBP Act
360

FGBP/INR - SGBP/INR
(rINR - rGBP ) (4)
SGBP/INR
The FX swap(forward) premium reflects the yield differential between two currencies. FX swap
traders are essentially taking a view on the swap premium (yield spread) between a currency pair.
They buy(sell) if they perceive that the spreads will widen(tighten).

Uncovered Interest Rate Parity(UIRP)


According to uncovered interest rate parity condition, the expected return on an unhedged(uncov
ered) foreign currency investment should equal the return on a comparable domestic currency
investment.

UIRP states that, the change in the spot rate over the investment horizon should, on an average,
equal the yield differential between two countries. That is, the expected appreciation/depreciation
of the exchange rate just offsets the yield differential. The current forward exchange rate is then, an
unbiased (correct on average) predictor of the future spot rate.

In domestic currency terms, the investment return on an uncovered GBPdenominated investment


is approximately equal to:
(1 + rGBP ) (1 + % SGBP/INR ) - 1
rGBP + % SGBP/INR
To be concrete, lets assume that the return on the oneyear GBP instrument is 10 percent, while the
return on the oneyear INR instrument is 5 percent. The allin domestic return depends on the
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future movements in the spot rate, which cannot be known until the end of the period. Consider 3
cases:

1. The GBP/INR spot rate is expected to remain unchanged.


2. GBP is expected to depreciate by 10%.
3. GBP is expected to depreciate by 5%.

In the first case, the investor would prefer the GBP instrument because (10% + 0%)=10% expected
return, while the INR instrument only offers 5%. In the second case, the investor would prefer the
INR instrument, because the expected return on the GBP instrument is (=10%+(10%)) 0 percent. In
the third case, uncovered interest rate parity holds because both investments offer a 5 percent
expected return (10%+(5%)).

Note that in the third case, in which the uncovered interest rate parity holds, although the expected
return over the oneyear investment horizon is the same, the distribution of the possible total
return outcomes is quite different. For our investor, the return on the INR money market instru
ment is known with certainty. In contrast, the distribution of the allin return on the GBP money
market instrument embodies the uncertainty with respect to the future SGBP/INR rate.

Uncovered interest rate parity asserts,


(1 + rGBP ) (1 + E[% SGBP/INR ]) = (1 + rINR ) (5)
-E[% SGBP/INR ] = rGBP - rINR (6)
-E[% SH/L ] = rH - rL (7)

Note that, with UIRP, highyield currencies are expected to depreciate. It is depreciation of the
currency that offsets the higheryield, so that the expected allin return on the two investment
choices is the same. Hence, if UIRP held consistently in the real workd, it would rule out the possibil
ity of earning excess returns from going long a highyield currency and going short a lowyield
currency. If UIRP held, the depreciation of the highyield currency would exactly offset the yield
advantage that the highyield currency offers. Taking this to its logical conclusion, if UIRP held at
all times, the investors would have no incentive to shift capital from one currency to another
because the expected returns on otherwise identical money market instruments would be equal
across markets.

Most studies find that UIRP fails to hold over short and mediumterm periods. Over short and
mediumterm periods, interest rate differentials have generally been found to be a poor predictor of
the future spot exchange rates. If highyield currencies fail to weaken in line with the path pre
dicted by UIRP, then highyield currencies should exhibit a tendency to outperform lowyield
currencis over time. If so, traders would adopt strategies that overweight highyield currencies at
the expense of lowyield currencies and generate attractive returns in the process. Such appraoches
are known as the FX Carry trade strategies.

Spot and forward rates as predictors of the future spot rates


According to CIRP, a countrys currency will trade at a forward premium if and only if the foreign
currency interest rate exceeds the domestic interest rate. When the base currency has a lower
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interest rate then the price currency, the base currency will trade at a forward premium. That is,
being a lowyield currency and trading at a forward premium is synonymous. Similarly, being a
highyield currency and a trading at forward discount is synonymous.

For example, suppose it is 25APR2016 and USD/INR spot = 66.4925. May USDINR futures are
trading at 67.1100 and June futures price is 67.4850. USD is trading at a forward premium because
rINR - rUSD 6 % - 2 % = 4 %.
Fb/p - Sb/p
(rp - rb ) (8)
Sb/p

A emerging market highyield currency like INR trades at forward discount with respect to other
currencies. A developed countrys lowyield currency like USD trades at a forward premium with
respect to other currencies.

As I have shown previously, if UIRP holds then the expected change in the spot rate is equal to the
interest rate differential.
-E[% Sb/p ] = rb - rp (9)

We can link these two equations by assuming that UIRP holds. If this is the case, then the FX swap
premium(discount) points, expressed in percentage terms, should equal the expected percentage
appreciation(depreciation) of the base currency.
Fb/p - Sb/p
= E[% Sb/p ] (rp - rb )
Sb/p
Fb/p - Sb/p
= E[% Sb/p ] (10)
Sb/p

Thus, in theory the forward exchange rate will be an unbiased forecast of the future spot exchange
rate if both CIRP and UIRP hold. Asking whether the forward exchange rate is an unbiased predic
tor of the spot exchange rate is the same as asking whether UIRP holds.

How might the UIRP and with it, the equality of the forward exchange rate and the expected future
spot spot exchange rate be enforced? If the currency forwards are trading above the speculators
expectation of the future spot rate and they believe the yield spread will tighten, they will sell for
wards, pushing the forward premium down; conversely if the forwards are underpriced and specula
tors believe the spreads will widen, they buy forwards, pusing the forward prices up.

UIRP in general is always violated. The spot exchange rates are volatile and determined by a com
plex web of influences. In general, forward exchange rates are poor predictors of the future spot
exchange rates.

Current spot exchange rates are not good predictors of future spot exchange rate either.

Purchasing power parity(PPP)


The law of one price asserts that, identical goods should trade at the same price across countries
when valued in terms of a common currency. The foreign price of a good should equal the exchange
rateadjusted price of the identical good in the domestic country. The aggregate domestic price
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goods should equal aggregate foreign price of goods multiplied by the exchange rate. This is a goods
arbitrage.
Pd = Pf Sf/d
Pd (11)
Sf/d =
Pf
The relative version of the PPP implies that the exchange rate changes offset the changes in the
competitiveness arising from inflation differentials.
E[% Sf/d ] d - f (12)

For example, if Indias inflation rate equals 5% and the US inflation rate equals 1%, then INR should
depreciate by approximately 4%(=5%1%). High inflation currencies should depreciate relative to
lowinflation currencies, so that the exchange rate depreciation offsets the competitiveness arising
from inflation differentials.

Studies have found that over short horizons, nominal exchange rate movements appear haphazard,
but over longer term horizons, nominal exchange rates gravitate over their long run equilibrium
values.

The Fischer effect and real interest rate parity


According to Fischer, one can break down the nominal interest rate in a given country into two
parts (1) the real interest rate in that particular country and (2) the expected inflation rate in that
country.
i = r +
Thus, we can write a Fischer equation for both a domestic country and a foreign country.
id = rd + d
if = rf + f

Because nominal interest rate differentials play an important role in both CIRP and UIRP calcula
tions, lets take a closer look at the forces that drive the trend in the nominal yield spreads. Subtract
ing the top equation from the bottom equation shows that nominal yield spread between the for
eign and domestic countries equals
if - id = (rf - rd ) + (f - d )
(rf - rd ) = (if - id ) - (f - d )

If moneymarkets arbitrage (UIRP) held then,


-E[% Sf/d ] = (if - id )
If goodsmarket arbitrage(PPP) held then,
-E[% Sf/d ] = (f - d )
If both the above conditions hold,
(rf - rd ) = 0
rf = rd

If this is the case, the level of interest rates in the domestic country will be identical to the level of
interest rates in the foreign country. The proposition that the real interest rates will converge to the
same level across different markets is known as the real interest rate parity condition. This concept
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can also be interpreted as an application ofthe law of one price to securities internationally.

If the real interest rates are equal across the markets, then it also follows that the foreigndomestic
yield spread will be solely determined by the foreigndomestic expected inflation differential.
if - id = (f - d )
This is known as the international fischer effect.

The Carry Trade


According to UIRP, highyield currencies are expected to depreciate, while lowyield currencies are
expected to appreciate in value. If UIRP held at all times, investors would not be able to profit from
a strategy that undertook long positions in baskets of highyield currencies and short positions in
baskets of lowyield currencies. The change in the spot rates over the tenor of the forward contracts
would cancel out the interest rate differentials locked in at the inception of the position.

UIRP is the most widely tested propositions in the field of finance. Literally, hundrededs, if not
thousands of academic studies have tested whether UIRP has held for both developed and emerging
market (EM) countries. Overwhelmingly the evidence suggests that UIRP does not hold, atleast
over shortterm and medium runtime periods. Highyield currencies, on average, have not depreci
ated and lowyield currencies have not appreciated, to the levels predicted by interest rate differen
tials.

This persistent violation of the UIRP is often referred to by academics as forward rate bias. An
implication of UIRP is that the forward rate should be, on average equal to, the future spot rate. Put
different, the FX swap premium(discount) expressed in percentage terms should equal the expected
percentage appreciation (depreciation) of the currency. The historical data, however, show that the
forward rate is not the mean of the distribution of future spot rate; in fact it is a biased predictor.
Hence, the name forward rate bias. The forward premium often overstates the amount of apprecia
tion of the base currency and the discount often overstates the amount of depreciation of the base
currency.

The FX carry trade strategy of taking long positions in highyield currencies and short positions in
lowyield currencies (the funding currency) is equivalent to trading the forwardrate bias. In other
words, you buy currencies trading at a forward discount(buy low) and sell currencies trading at a
forward premium (sell high).

The gains that one earns through the carry trade (or equivalently through trading the forward rate
bias) can be seen as risk premiums that is for absorbing the currency risk). Long periods of mar
ket stability can make these extra returns enticing to many FX traders, and the longer the yield
differential persists, the more carry trade positions tend to build up. But, the highyield currency
advantages can be erased quickly, if the global financial markets are subject to stress. Remember,
that the FX carry trade is essentially a leveraged trade you borrow in the lowyield currency and
invest in the highyielding currency. These occassional large losses mean that the return distribu
tion for the carry trade has a pronounced negative skew.
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This negative skew derives from the fact that the funding currencies of the carry trade are typically
safehaven currencies like USD, CHF and JPY. In contrast, the investment curencies are typically
perceived to be higher risk, such as several EM currencies. Any time the global financial markets are
under stress, there is a flight to safety, that causes rapid movements in the exchange rates and
usually a panicked unwinding of the carry trades. As a result, traders running carry trades often get
caught in losing positions, with leverage magnifying their losses.

Because of the tendency of long periodsof relatively small gains in the carry trade to be followed by
brief periods of large losses, the carry trade is likened to picking up nickels in front of a steamroller.