Interest Rates, Carry Trades, and Exchange Rate Movements

This reading, "Interest Rates, Carry Trades, and Exchange Rate Movements." explains how a carry trade works and examines whether carry trades based on interest-rate differentials between countries can be responsible for significant swings in foreign exchange rates. Although in theory the answer is no, the forward premium puzzle explains why carry traders can profit from their investment strategies.

1. Define the following terms used in the reading:
   1. carry trade
   2. funding currency
   3. target currency
   4. spot exchange rate
   5. forward exchange rate
   6. forward premium
   7. covered interest parity
   8. uncovered interest parity
   9. forward premium puzzle
   10. exchange rate risk

2. What are the two versions in which a currency trader can execute a carry trade strategy? Why are these two versions equivalent?
3. Explain why carry trade strategies should in theory yield zero profits. How does the forward premium puzzle help explain why investors are able to profit from carry trades?
4. How and why do carry trades cause appreciation and depreciation of funding and target currencies? Can carry trades be responsible for large swings observed in currency markets? Explain.

Source: "Interest Rates, Carry Trades, and Exchange Rate Movements." Michele Cavallo, FRBSF Economic Letter No. 2006-31, Federal Reserve Bank of San Francisco, November 17, 2006.