Explanation:
FX carry trades involve borrowing in low-interest-rate currencies and investing in high-interest-rate currencies. According to uncovered interest rate parity (UIP), high-yield currencies should depreciate to offset the interest rate differential, making carry trades unprofitable. However, empirical evidence shows that high-yield currencies often do not depreciate as much as predicted by UIP, allowing carry trades to generate profits in short and medium time periods.
Key points:
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Foreign exchange (FX) carry trades have been profitable in short and medium time periods because:
A
low-yield currencies reflect a more unstable economy.
B
the return to the trader consists of credit risk and currency appreciation/depreciation.
C
high-yield currencies do not depreciate to levels predicted by interest rate differentials.