Carry Traders, Dealers, and the Forward Discount Anomaly

Discussion in 'Forex' started by mr double, Mar 9, 2007.

  1. full article:

    Can you please explain the second paragraph for me? I don't understand what 'pre-funding' is, or why the FX dealer earns interest when buying the currency with the lower interest rate of the two countries

    Currencies do not depreciate enough to offset differences in interest rates. If specialist "carry traders" and foreign exchange (FX) dealers are price-setters in equilibrium, this result is not surprising. Carry traders do not borrow in one currency and lend in another, as standard uncovered interest parity (UIP) requires. They finance positions in the repo markets, earning benchmark bond returns and paying interest at local repo rates. Ceteris paribus, there should be a forward discount "bias" whenever they are long foreign currency.

    All else may not be equal. Someone must sell the currencies they buy. If this someone is an FX dealer, second-day FX settlement permits "pre-funding" of deliveries. By pre-funding dealers hedge currency risk and earn interest premiums for the currencies they sell. In equilibrium, depreciation should reflect both differences in interest rates and benchmark bond returns, with signs reversing based on the direction of trade. With 10 years of daily data for 6 major currencies, I confirm these predictions.

    Carry Traders, Dealers, and the Forward Discount Anomaly

    University of Virginia - Darden Graduate School of Business Administration February 25, 2005