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Carry Trades – Interest Rate Differentials

Carry Trades – Interest Rate Differentials

In foreign exchange markets the prices of currencies are quoted in pairs as rates, with one currency called the base currency quoted against another currency called the terms currency. Therefore, one of the key determinants of exchange rate movements is the interest rate differential between two currencies rather than the  interest rate of a single currency. By understanding the concept of carry trades and the no arbitrage model we will understand how interest rate differentials have an impact on exchange rate movements between two currencies. 

Interest Rate Differentials and Carry Trades

Let us begin by understanding what interest rate differentials and carry trades are and why they are important for the foreign exchange markets.

Interest rate differentials (IRDs) are basically the difference in the interest rates between two similar assets. Therefore, if the US dollar one-month interest rate was 3% and the British Pound one-month rate was 6% then the GBP/USD interest rate differential would be 3% for a 1-month term.

To understand carry trades and the impact of the IRD on carry trades, we see from the figure below that if the GBP/USD exchange rate was 1.45 then one could borrow 1.45 million USD at 3%, sell the 1.45 million USD in exchange for 1 million Great Britain Pounds (GBP) and place the 1 million pounds (GBP) in a one month deposit at 6%. 

Traders therefore borrow in the lower interest rate currency, which in our case is the USD, and lend in the higher return currency to lock in the interest rate differential. One could then earn the interest rate differential of 3% annualized (ignoring transaction costs) and make a gain of roughly $948 over one month.

If the GBP/USD rate remains unchanged after one month, then the total return would be the return earned on the interest rate differential. However, if the currency moves to 1.46 after one month, the trader could sell the 1 million GBP + the gains made on the deposit at a good profit. However, if the exchange rate falls to 1.44 this trade suffers a loss.  As long as the interest rate differential remains the same investments in the British Pound continue to remain attractive.

Interest Rate Differentials and Carry Trades

FX Carry Trades Image

FX Carry Trades

Now lets assume that the US dollar rates move from 3% to 4% bringing the differential down to 2%. The GBP/USD carry trades now look less attractive since the interest rate spreads have decreased.

Interest Rate Differentials and Carry Trades

FX Carry Trades Image

FX Carry Trades

In addition, as we have seen earlier in the book discussing bond markets, when the dollar interest rates move higher bond prices head lower, making the US bond markets very attractive for foreign investors. Foreign investors will therefore need to buy dollars against their domestic currencies in order to invest in US bond markets, thereby increasing the demand for US dollars and pushing its rate up against other currencies.

When the interest rate differential reduces to 2% due to an increase in interest rates the USD will benefit, pushing the GBP/USD rate to 1.44 and thus incurring a loss on the GBP/USD carry trade as can be seen in the figure below.

Image Forex rates and interest rate differentials

Forex rates and interest rate differentials

Hot money flows in and out of a country is an important reason for a currency’s appreciation or depreciation. A higher dollar interest rate also decreases the interest rate differentials between the dollar and other currencies such as the Yen, Euro, and Chinese Yuan making the US a hot destination for foreign investments.

While interest rate differentials are the main determinant of exchange rate movements there are other factors that we should not ignore such as central bank intervention, political uncertainty, and high inflation rates. High inflation rates corrode the purchasing power of the currency making it less attractive for investors.

Conclusion

We now have a sufficient understanding of the functioning of the FX markets for our purpose. We  also understand the one of key determinant of currency pair movements, interest rate differentials. Whichever markets we are invested in, it is of utmost importance to have a working knowledge of what economic factor influences that particular market and in what capacity. To predict the direction of financial markets we need to ultimately predict the direction of interest rates, growth rates, and inflation rates, and the impact of these economic factors on the determinants of asset prices.

Next we dive right into of the most crucial economic concepts for all of us to understand— the Gross Domestic Product, or GDP. We talk and read about economic growth, and feel its impact on our daily lives, especially on our income and spending. We have experienced recessions and their ability to shatter our confidence in buying a new house or a new car. Therefore, the impact of a country’s economic health on our daily lives is apparent and it is important for us to understand one single measure of the economic growth and its impact on our lives – the Gross Domestic Product.

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