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I know that carry is an important factor to value currency. However, it is not obvious to me how you can actually earn the carry return, and if as a pure currency investor, should not you be interested only in the spot return. For example, if country A has a 3m interest rate of 2% and country B has a 3m interest rate of 10%, assuming the exchange rate remains constant, you can earn 8% in 3m. However, if I just buy the currency of country B at the beginning of the period and I sell it at the end of the 3m, I have not earned anything. Thus, am I right assuming that the importance of carry is that it attracts investments in the currency of country B, pushes up its demand and thus makes just more likely that it will appreciate in the future? Or you can actually earn this 8% just buying the currency and holding it (I mean a bank of that country can just deposit the money at the central bank, but a foreign bank or a private investor cannot) ?

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  • $\begingroup$ I voted to close this question because I think it is not suited for quant se. Just a remark, interest parity would actually imply that currency B depreciates. Otherwise you would gain on the interest rate plus the appreciation. $\endgroup$
    – AKdemy
    Apr 23, 2023 at 11:13
  • $\begingroup$ @AKdemy: I totally understand your point and I was inclined to also vote to close this one, but there is a practical / practitioner element that is interesting: how do you earn interest by just buying and holding a foreign currency (I wasn't really aware of Nostro accounts until I sat on a treasury desk, it's one of those things difficult to find in a text-book): but yes, otherwise the question is very basic. $\endgroup$ Apr 23, 2023 at 11:28
  • $\begingroup$ @AKdemy I was indeed curious about how in practice you can earn interest. That said, I am not sure that in my example currency B will depreciate. I understand that to price forwards in a way that precludes arbitrages you have to assume that it will be the case, but in reality I think it is an open question (that is why to me it makes sense to consider high carry as a positive factor for a currency). $\endgroup$
    – Peter
    Apr 23, 2023 at 12:17

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Practically, if you have access to the financial markets, you can earn that interest.

On day one, you sell your domestic currency denoted $X_d$ (where the 3m prevailing rates are 2%) and you buy the foreign currency $X_f$ (where 3m prevailing rates are 10%). If you leave this position unhedged, your foreign currency will be sitting in a Nostro account

(see this wiki link for Nostro account explanation: basically, a Nostro account is a bank account in a foreign country, with a domestic bank in that country, which allows you to hold the local currency: so if you buy $X_f$, that money will be sitting in the Nostro account with a domestic bank in that country: and usually that bank will remunerate that balance with the prevailing rate (say 10%) minus some spread: so that's one way to earn the interest).

(Btw, many people might not realize this, but when you buy a foreign currency, unless you bring it back to your country as paper bills, that currency will "physically" never leave the home country: it will always be sitting in some local Nostro account: that's how central banks control the supply of money, digitally, that money never leaves the domestic country, because only domestic licensed banks can hold the local currency digitally: that's how money works, a fascinating subject in itself).

Another way to earn that interest is to use an XCCY-Swap: once you own the currency $X_f$, you can "swap" it out for 3 months in the financial markets using an XCCY-swap: then, you will earn the 10% rate plus or minus the prevailing FX basis and you will in exchange get a currency of your choice, on which you pay the prevailing interest rate in that currency plus or minus the prevailing FX basis.

Note however, that all these positions described above are unhedged: you can lose a lot of money on the change in FX rates.

If you wanted to hedge with an FX forward, the covered FX parity would ensure that you make no money on the trade.

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