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FRM Part I · FRM Exam Part I · Foreign Exchange Markets

A trader borrows in a low-rate currency and invests in a high-rate currency without hedging. Which outcome is consistent with uncovered interest parity holding on average?

If uncovered interest parity holds, the high-interest currency is expected to depreciate by about the interest differential, so the unhedged carry trade has zero expected profit. Actual results remain uncertain, so it is not a risk-free gain or a certain loss.

  1. AThe trader earns zero expected profit because the high-rate currency is expected to depreciate by the interest differentialCorrect
  2. BThe trader earns a risk-free profit equal to the interest differential
  3. CThe trader loses the full interest differential for certain
  4. DThe trader earns profit only if inflation differentials are zero

Explanation

UIP implies the expected depreciation of the high-rate currency offsets the interest differential, so expected excess return is zero, though realized outcomes are risky. Empirically, UIP often fails, which is why carry trades have earned positive average returns with crash risk.

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