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FX Carry and Hedging

One-line definition

FX carry is the interest-rate differential earned (or paid) holding a foreign currency unhedged; hedging removes that differential along with the currency risk.

Formula

carry = r_foreign - r_domestic

Why PMs care

Uncovered interest rate parity (UIP) predicts spot should move to offset this differential exactly — a carry trade is a bet that it won't, on average, which has historically been a persistent (if crash-prone) risk premium in FX markets.

Hedging

Reuse hedge_ratio() from src/pm/fixed_income/duration.py — it's a generic DV01/notional-sizing formula, not fixed-income-specific. Hedging foreign currency exposure back to domestic currency uses a forward contract sized to the foreign-currency notional; the cost of that hedge is exactly the forward points implied by fx_forward_rate (i.e., you give up the carry you'd otherwise earn/pay unhedged).

Common mistakes

  • forgetting the sign convention: carry is positive for the PM earning the higher rate, i.e. long the higher-yielding currency
  • assuming carry is riskless income — it's compensation for the risk that UIP fails to hold and the currency depreciates by more than the differential (or crashes, as in a "carry unwind")