Special Topic: Currency Carry Trade

Why carry trades work in calm markets, why they blow up in stress events, and how CIRP (covered) differs from UIP (uncovered). Includes IRP homework with interactive calculators: spot-from-forward, forward-from-spot, arbitrage check, triangular arbitrage, and a carry-trade shock simulator.

Theme
Video Discussion

Currency Carry Trade – the “easy yield” strategy

What is it?

  • Borrow in a low-interest-rate currency (funding currency).
  • Convert into a higher-yield currency (target currency).
  • Invest at the higher interest rate and collect the spread.
  • Typically unhedged (that is the “uncovered” part) → FX risk is the real danger.
Why it works (when it works): rate differentials are wide, FX is stable, volatility is low, and funding currencies (JPY/CHF) do not suddenly strengthen.
Why it causes chaos (when it fails): when risk spikes or a central bank surprises (e.g., funding-rate hikes), investors rush to unwind. Funding currencies can appreciate fast → repayment cost jumps → forced selling spreads across markets.

Common carry-trade currencies (typical classroom examples)

CurrencyUsed forWhy
JPY Funding Historically low rates; large, liquid markets; “safe-haven” behavior in stress.
CHF Funding Low rates; also safe-haven; used when volatility is subdued.
USD (or other higher-yield) Target Higher yields in tightening cycles; deep asset markets; attractive to global investors.

Suggested videos (add your own links)

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Theory Quiz

Covered Interest Rate Parity (CIRP) vs Uncovered Interest Parity (UIP)

Feature Covered IRP (CIRP) Uncovered IRP (UIP)
Uses forward contract? Yes — forward rate is locked in No — relies on expected future spot rate
Exchange-rate risk Hedged — no exposure Exposed — FX movements can dominate returns
Core assumption No arbitrage in covered markets Expected returns equalize across currencies (even with FX risk)
Theory predicts Forward premium/discount reflects interest differential High-interest currency depreciates to offset higher rate
Real market behavior Usually holds (arbitrage enforces it) Often fails (creates carry-trade opportunities)
Investor action Arbitrageurs exploit forward mispricing Traders borrow low-rate currency, invest in high-rate currency
Exam-safe line: CIRP is an arbitrage condition. UIP is a risk/expectations condition that frequently fails in data — which is why carry trades can exist.
Calculator IRP

IRP Tools (interactive)

CIRP calculator (quote = $/€)

Convention used here: exchange rate is quoted currency per 1 base currency (example: $/€). That means the base is EUR and the quoted is USD.

With quote $/€:
F = S × (1 + i$) / (1 + i€)
S = F × (1 + i€) / (1 + i$) 
Output will appear here.
If “profit” ≈ 0, CIRP holds. If profit is positive for one direction, an arbitrage loop exists (ignoring costs/limits).

Triangular arbitrage calculator (USD → EUR → GBP → USD)

Output will appear here.
Arbitrage pushes rates to adjust until the loop profit disappears.

Carry-trade “shock” simulator (JPY funding → USD investing)

This is a simplified classroom model: carry return ≈ interest spread + FX move (USD/JPY).

Output will appear here.
Interpretation: if USD/JPY falls (JPY strengthens), that FX move hurts a JPY-funded carry trade because repayment is more expensive in USD terms.
Homework Due with final

Homework (Chapter 7: IRP + arbitrage)

1) Spot rate implied by CIRP (given F)
2) Spot rate eliminating arbitrage (given borrowing rates + F)
3) One-contract futures/forward arbitrage profit test (10,000€)
4) Solve US interest rate from IRP
5) Triangular arbitrage (USD/EUR/GBP)
6) Carry trade question (early 2025 setup + Japan surprise)
Educational disclaimer: These solutions ignore bid–ask spreads, transaction costs, position limits, funding constraints, taxes, and settlement frictions.
Special Topic Discussion

Special Topic: Domestic and global implications of tariff policy (discussion prompts)

Use this section as a structured discussion (or a short reflection assignment). Keep answers focused on mechanisms: prices, supply chains, retaliation, exchange rates, and capital flows.

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Home questions (due with final)

  • What economic effects would a blanket tariff have on consumers and businesses?
  • How might affected countries respond?
  • Are tariffs effective tools for strengthening national economies? Why or why not?
  • Which domestic reactions (support/concern) do you find most compelling, and why?
Instructor notes (optional)
Suggested angles:
  • Incidence: who bears the cost (consumers vs firms) depends on pass-through and competition.
  • Retaliation: partners may impose counter-tariffs; export industries can be hit.
  • FX channel: tariffs can influence the trade balance and the currency (direction depends on capital flows).
  • Supply chains: firms may re-route sourcing; short-run disruption vs long-run re-optimization.
  • Financial markets: risk sentiment and uncertainty can move FX faster than goods prices.