Carry trade question

CFA Level III
#1

Subscriber 3
“India has relatively high interest rates compared to the United States and my market view is that this situation is likely to persist. As a retail investor actively trading currencies, I am considering borrowing in USD and converting to the Indian rupee (INR). I then intend to invest these funds in INR-denominated bonds, but without using a currency hedge. "Which of the following market developments would be most favorable for Subscriber 3’s trading plan?

  1. A. A narrower interest rate differential.
  2. B. A higher forward premium for INR/USD.
  3. C. Higher volatility in INR/USD spot rate movements.

How is B correct? A higher forward premium would mean USD expected to appreciate and INR expected to depreciate, this would offset the gains of carry trade right?

#2

Only if uncovered interest rate parity holds; carry trade is based on the hope that it doesn’t hold.

What the higher forward premium does tell you, for certain, is that the interest rate differential is higher, so you’ll make relatively more money investing INR than USD.

1 Like
#3

Makes sense now, thank you Magician!

#4

My pleasure.