10.2 The Carry Trade: Basic Facts
10.2.1 What is a Carry Trade?
In the carry trade, an investor borrows funds in a low interest rate currency and lends in a high interest rate currency. Here, I let the domestic currency be the US dollar (USD) and denote the rate of interest on riskless USD denominated securities as it. I denote the interest rate on riskless foreign denominated securities as
. Abstracting from transactions costs, the payoff to borrowing one USD in order to lend the foreign currency is
10.1 ![]()
where St denotes the spot exchange rate expressed as USD per foreign currency unit (FCU). The payoff to the carry-trade strategy is, therefore:
The carry-trade strategy can also be implemented by selling the foreign currency forward when it is at a forward premium (Ft ≥ St) and buying the foreign currency forward when it is at a forward discount (Ft < St). If the number of FCUs transacted forward is normalized to be (1 + it)/Ft, then the payoff to this version of the strategy, denoted zt+1, is
Covered interest rate parity (CIP) implies that
10.4
When CIP holds, the expressions ...