How does the Carry Trade Work?
I'm working my way through Hull right now and am becoming more familiar with discounting and forward pricing. However, the existence of interest rate parity and the carry trade seem to contradict each other. How does the carry trade work if it is in theory eliminated by forward pricing based on interest rates to prevent arbitrage? I'm specifically curious in relating this to foreign exchange, but an explanation related to any asset would be helpful.
Essentially, carry trades is to earn income from holding an asset. So it's the coupon income of the bond less the financing cost. Remember for P/L of an asset, it's the holding asset (carry) plus price change in asset, so carry trades are favored during periods when interest rates are anchored at shorter maturities or when volatility is low. For a carry trades to be attractive, small changes in price (yields) is desirable, so P/L is lower. This could be considered high risk-adjusted P/L. If the day to day P/L is in your favor, of course that's beneficial but that is not the main purpose of a carry trade.
You borrow cash at a low financing cost, you buy bond... Bond's coupon is a higher than the cost of financing. In return, you want low volatility leading to high risk adjusted return but if MTM P/L is in your favor, great but if it goes against you, bad. But you don't want any MTM P/L
I don't fully understand. Is the main point that interest rate discounting won't apply 100% because there is some credit and market risk in the bond purchased, so the investor making the carry trade is earning a premium for holding the risk?
Edit: Actually I totally get what you're saying. I guess now I'm still struggling to relate it to FX because in theory both sides should be risk free.
You can earn money if the forward curve is in carry structure.
September Cocoa Future sells at 2400 December Cocoa Future sells at 2350 March Cocoa Future sells 2300
You hold the asset and when the September contract goes of the board you sell it and buy with the proceeds (2400) the December contract (-2350). This makes you a 50 USD profit. Do the same with Dec/March Spread and you earn another 50 USD.
The general idea of a carry trade is that you (a) collect some form of predictable drift arising from an non-arbitrage relationship (forward price bias, cash-and-carry etc) while (b) withstanding volatility of the asset.
In FX your forward rate price is literally a combination of spot FX and two deposits. If the rate differential is high enough, the forward price will be massively different. That means if you actually buy that forward in a naked form and it converges to the current spot, you are essentially collecting the interest rate differential for as long as you have the balls to withstand the volatility of the spot exchange rate. Alternatively, you can buy spot and simply collect the interest rate differential in the overnight rates.
*A currency trader named Larry
Liked to collect lots of carry
He shorted some yen
And was subsequently canned
But found a new job in a hurry*
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