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CARRY TRADE IN CURRENCY FUTURES

The four major currency pairs traded on Indian exchanges, namely USDINR, EURINR, GBPINR, and JPYINR, all exhibit a common characteristic:

Futures contracts on each of these currency pairs consistently trade at a premium over the spot exchange rates. This premium can be primarily attributed to the interest rate differential between the two currencies involved. It serves to eliminate arbitrage opportunities between the respective currencies, which is why it exists in the futures or forward contracts. In essence, the premium reflects the cost of carrying a position in these currency pairs due to the interest rate disparities.

For example, consider the scenario for USDINR:

1. The spot exchange rate for USDINR is 83.22.

2. The USDINR futures contract with a November 28th expiry is quoting at 83.29, which implies a premium of 7 paise over the spot rate.

Currency carry traders are keenly interested in this premium. They engage in carry trading by speculating on the appreciation of the Indian Rupee against currencies like the US Dollar, Euro, British Pound, or Japanese Yen. To do this, they take short positions in futures contracts and hold them until the contract's expiry. Once the contract matures, they often roll their positions into the next month's contract.

For instance, let's examine the situation with JPYINR:

1. The spot exchange rate for JPYINR is 55.44.

2. The JPYINR futures contract with a November 28th expiry is quoting at 55.84, indicating a premium of around 40 paise over the spot rate.

A currency carry trader who anticipates the Indian Rupee appreciating against the Japanese Yen over the next six months might choose to sell JPYINR November futures at 55.84. When the November contract reaches its expiry date (28th November), and if the futures rate has decreased to 55.00, the trader closes their short position in the November contract and opens a new position in the December contract, thereby repeating the cycle.

It's important to note that this type of trading strategy is associated with high risk because futures contracts can result in unlimited losses if the prices move against the trader. Therefore, carry traders must implement rigorous risk management measures, including setting appropriate position sizes and stop-loss orders. Unexpected large gap up openings in prices can lead to substantial losses, underscoring the need for caution. Consequently, carry traders must carefully assess the currency's dynamics and the inherent risks before engaging in such trades. 

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In summary, the carry trade strategy is popular among currency speculators, but it should be approached with a high level of risk awareness, comprehensive analysis of the currency pairs involved, and a strong understanding of risk management principles.

Here's the table showing the current premiums of near-month month-end futures over spot rates for the mentioned currency pairs