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Usually carry trades involve borrowing in a low yield currency and invest in a high yield currency. For example, I borrow dollars and invest in Brazilian real. I then use a rolling FX swap to hedge the FX risk (eg sell dollars spot and buy them back forward).

I recently read about a different carry trade on the Mexican peso that involves the following (below detailed description):

step 1: buy spot MXN

step 2: enter a FX swap where you sell MXN spot and buy it back forward

Would you be able to explain the rationale behind this?

"Carry trades (often implemented by hedge funds) would shift foreign currency provision from spot to FX forward markets. If MXN is the destination currency, market intelligence indicates that foreign investors would usually buy MXN spot, then implement an FX swap selling MXN spot and buying MXN forward. Here FX supply in the spot market is unchanged (the spot transactions cancel out), but foreign investors commit to supply USD in the FX derivatives market, as a result of their USD short/MXN long position. In the case of a carry trade, this position would be unhedged (there is no offsetting demand for foreign currency) and of very short maturity, thus implying rollover risks".

extract from page 23 of this BIS paper: https://www.bis.org/publ/bppdf/bispap90.pdf

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"Would you be able to explain the rationale behind this [buy spot...enter a FX swap where you sell spot and buy it back forward]?"

Very few accounts want to take delivery of a spot position therefore they roll via the swap.

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Buy MXN spot and then swap MXN spot with forward is equivalent to an outright forward in MXN.

Outright forwards are one well established way of implementing the Carry Trade.

Why they prefer to do it in 2 steps rather than one, I don't know.

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  • $\begingroup$ yes it's the same thing, difficult to understand the logic. Can you suggest any resources that describe in detail how carry trades are executed? thanks $\endgroup$
    – Student
    Feb 25, 2021 at 10:37
  • $\begingroup$ The 2 main ways to do carry trades: borrowing/lending or forward contracts are explained in many places, for ex here on page 3 kellogg.northwestern.edu/faculty/rebelo/htm/carry.pdf or in this previous question quant.stackexchange.com/questions/19052/… Either you actually borrow and lend real money or you do it with derivatives (fwd contracts) $\endgroup$
    – nbbo2
    Feb 25, 2021 at 13:46

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