Carry Trade and Interest Rate Differentials
The carry trade borrows in a low-yielding currency and invests in a high-yielding one, earning the difference.
Borrow yen at 0.5%, convert to Australian dollars, invest at 4%, and earn roughly 3.5% a year as long as the exchange rate holds still.
Why theory says this should not work
Covered interest parity fixes the forward rate so that hedging the currency risk removes the profit exactly. Hedged carry earns nothing; that is arithmetic, not a theory.
Uncovered interest parity goes further and claims that expected spot movement equals the differential, so the high-yield currency should be expected to depreciate by precisely the carry earned. If true, unhedged carry has zero expected return.
Why it has worked anyway
Empirically, high-yield currencies have not depreciated as much as forwards implied. This is the forward premium puzzle, one of the most studied anomalies in finance, and it is why carry has been a persistently profitable strategy.
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