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FX carry trade is pretty clear to me when one's trading currencies physically. The return for this trade will depend on the interest rate you're paying for the USD borrowed, the foreign interest rate received by lending the foreign currency and changes on the FX rate.

What I don't understand is why trading FX Futures can also be deemed a carry trade. I mean, I'm not paying or receiving anything by borrowing/lending currencies - the trade PnL seems only to depend on FX rate changes between the day the trade is executed and its maturity.

I'm aware of UIP and how local and foreign interest rates go into pricing FX Futures.

EDIT: To be clearer, I'm concerned about the case in which there is market risk. For example, on page 4 of this CME's document, right after an example of FX carry trade has been given, it says:

This transaction can also be executed in the futures/forward market by simply purchasing the desired currency pair, which is equivalent to buying one currency and selling the other.

Why trading the FX Futures is then the same as trading currencies physically?

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You are correct. In order for this to be a pure fx carry trade with no market risk (just credit risk), you have to have 2 fx trades. One shorter dated and the other longer dated.

Typically, you this will be done where you buy a currency spot and sell that same amount of currency in the future, in your case through an FX future. The difference between where you bought the currency and where you sold it in the future would be the carry that you earn.

As an example, say you bought 1MM USD of JPY at spot 115.89, you will pay 1MM USD and receive JPY 115,890,000. And through a fx future, you sold that JPY 115,890,000 on Jun 15 at 115.6652, you will receive USD 1,001,943.54. You will have earned USD 1,943.54 carry from now until Jun 15.

A few of things to consider however is 1) you will have to maintain margin for your futures position which will cut into your carry; 2) with negative interest rates, you will be paying interest on the spot currency you own (eg EUR, JPY etc). Your bank will charge you for having a balance in these currencies (again, cutting into the carry you will earn) and; 3) Futures are standardized contracts and you will have to buy and sell in increments of the notional of the future.

Edit for your edited question: In your example from the CME paper, the investor is short USD, long AUD at a future date. The investor has agreed to purchase AUD (paying in USD) at the agreed upon price in the future when they entered the contract. As such they are now long AUD and have market risk to USD/AUD exchange rate. Provided they still hold the future at maturity, the exchange will assign the trade to them and they will have to deliver the USD they agreed to pay and receive the AUD they agreed to buy.

If this exchange rate had moved unfavorably for the investor by the time to settle the future, they will be buying AUD at a price that is higher than the spot. Should they want to take the AUD risk off at that point they would convert the AUD to USD at spot and lose money on the trade. (Of course the spot exchange rate could have moved into their favor and they would have been buying AUD cheaper).

Futures contracts embed the term rates for the underlying currencies into the contract price (the price that the investor will agree to purchase the AUD in the future via the futures contract). One way to visualize the this: (1) if an investor would need to deliver USD in the future for the AUD, how much would they have to set aside now to make good on that obligation? The amount that the investor would set aside would be earning the USD term interest rate to the future date and (2) How much interest would this investor forego by agreeing to take the AUD in the future rather than now? Had they purchased AUD now, they would have earned the AUD term interest rate to the future date.

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  • $\begingroup$ Thanks for this very clear explanation. I`ve edited my question. $\endgroup$
    – SuavestArt
    Commented Jan 13, 2022 at 13:23
  • $\begingroup$ @Rafael Edited response to address your edited question $\endgroup$
    – AlRacoon
    Commented Jan 13, 2022 at 15:25
  • $\begingroup$ You said "The amount that the investor would set aside would be earning the USD term interest rate to the future date". So this is the same as the long AUD/ short USD position to be paying its counterparty the USD interest rate over the PV of the USD notional to be sold in the future. So a higher USD interest rate is worse to the long AUD investor. Is that correct? $\endgroup$
    – SuavestArt
    Commented Jan 15, 2022 at 20:16
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    $\begingroup$ @Rafael. That is correct. If USD rates rise more than AUD rates, the USD will appreciate vs the AUD and the investor that is long AUD will lose. $\endgroup$
    – AlRacoon
    Commented Jan 15, 2022 at 20:48
  • $\begingroup$ I think I finally got this right. Thank you. $\endgroup$
    – SuavestArt
    Commented Jan 15, 2022 at 21:42
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I get your point... but don't understand your objection ;-)

If I sell say the USDTRY, USDBRL and USDRUB March futures, these might be 2m forwards when I sell them. A month later, those same futures will be 1m forwards. So how has the pricing differential of the 1m fwd vs 2m fwd curve evolved???

So they will either have beaten their forwards or lost against them. Which is both a function of spot price fluctuations, AND ROLLING UP/DOWN THE FORWARD RATE CURVE.

As such, it very simply is EXACTLY the same carry trade as spot or physical. Lest there be arbitrage in them there mountains ;-)

The forwards might not change; but futures are forwards with an ever-declining tenor...

sorry but just not buying this argument, DEM

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    $\begingroup$ Glad my question have caught your attention. I often overhear that when one has a long position in a FX futures contract (say, long USD in USDBRL), one is long USD and short the "carry" - which is how practitioners refer to the interest rate differential between the traded currencies. I can't see that clearly and that's where the question came up. $\endgroup$
    – SuavestArt
    Commented Jan 15, 2022 at 19:33
  • $\begingroup$ Ah OK, I see the difference now, @rafael ;-) Doing this by futures/fwds locks in the t-time forward rate at the moment of entry, thus eliminating rate risk (at least for t-time) and isolating purely the FX risk relative to the rates priced at entry. Of course, the roll diminishes this impact in reality if rates do move. But I get your core point, and it's consistent. Cue arguments I don't desire about the definition of a "carry trade" ;-) $\endgroup$
    – demully
    Commented Jan 19, 2022 at 20:40

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