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FX Carry Trades

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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 form the building blocks of most models of exchange rate determina

tion. The key international parity conditions are as follows:

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.

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

2 On FX Carry Trade.nb

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

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).

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.

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

On FX Carry Trade.nb 3

future movements in the spot rate, which cannot be known until the end of the period. Consider 3

cases:

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.

(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.

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

4 On FX Carry Trade.nb

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.

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

On FX Carry Trade.nb 5

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.

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 )

-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

6 On FX Carry Trade.nb

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.

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.

On FX Carry Trade.nb 7

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.

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