Cross-currency carry trade & hedging

I’m having trouble understanding whether it is possible to hedge a cross-currency carry trade:

From CFAI: In order to eliminate currency exposure in an inter-market trade, the investor must, explicitly or implicitly, both borrow and lend in each currency.

From Schweser: A cross-currency carry trade cannot be currency hedged because the currency differentials will adjust for interest rate differentials (interest rate parity). An attempt at hedging would negate the interest rate differential that the carry trade is attempting to exploit.

So why can you eliminate currency exposure by taking a long + short position, but you can’t hedge currency risk? I’ve been trying to understand this concept but keep getting confused. @S2000magician if you have any wisdom here, it would be greatly appreciated

Thanks in advance for any thoughts

The whole point of carry trade is that you’re trying to earn a return that’s higher than your home currency’s risk-free rate. For an inter-market carry trade you don’t want to hedge the exchange rate exposure; hedging the exchange rate exposure would give you a net return equal to your home currency’s risk-free rate.

The borrowing-and-lending in each currency is the intra-market part: you might borrow at, say, the 2-year rate and lend at, say, the 10-year rate to pick up the interest rate differential on a normal yield curve.

Hmmm … I’m still a bit confused.

  1. I’ve seen problems in the book where the currency hedged position provides a net return greater than the risk-free rate (calculated as the carry trade return less the forward discount). Wouldn’t this be an example of hedging FX exposure with return above the risk-free rate? Or am I missing something? See example below.
  • U.K.: Projected local market return is the 6-month coupon + ending price divided by beginning price: ((2.1 / 2) + 101.29) / 100 = 2.34%. The GBP with a higher 6-month (LIBOR) interest rate of 1.4% versus the U.S. rate of 1.2% will trade at a forward discount. The periodic forward discount is (1.4 – 1.2) / 2 = 0.1%. The total currency hedged return will be 2.34 – 0.10 = 2.24%.
  1. Are we supposed to assume IRP holds? Isn’t the premise of a carry trade that interest rate parity does NOT hold?

  2. When you enter a a duration-neutral and currency-neutral trade, you can still generate positive net carry due to the steeper yield curve. I get this technically isn’t a hedge, but wouldn’t this be an example of a carry trade with zero exchange rate exposure (and zero interest rate exposure) but achieve a risk-free return?

I know these questions are long but thanks again. Getting really hung up on this topic

  1. For the UK example, if 6-month GBP LIBOR is 1.4%, why is a 2.1% coupon bond selling at par?

You may have seen examples of this, but they’re likely flawed, as this one is.

  1. Covered IRP always holds (despite what the curriculum says); uncovered IRP rarely holds, which is the basis of inter-market carry trade.

  2. No. Although you’re currency-neutral today, tomorrow you won’t be. (If you were, then you made a return of 0% on your intra-market trades.)

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Thank you, very helpful.

As for the example, the 2.1% coupon is on the 5-yr UK bond. The question also states “Calculate the currency hedged and currency unhedged return. Assume the only position is long the 5-year bond.”

So perhaps that’s where I got tripped up … since you’re not hedging a cross-currency carry trade here? Just hedging a long bond?


So . . . the problem is that GBP 101.29 price in 6 months. That assumes that interest rates do not evolve according to the current forward curve. (Of course, they never do in the real world.) It makes a specific assumption about what interest rates will be in 6 months. That assumption may prove true, and it may not. On the exam, economists and portfolio managers are flawless prognosticators.