Carry adjustment in FX forward contracts is an important concept for currency traders to understand. It refers to the difference in interest rates between the two currencies being traded, and how that difference affects the price of the forward contract.
When two parties enter into an FX forward contract, they agree on an exchange rate for a future date. For example, if a trader wants to buy euros in six months` time, they might enter into a forward contract with a counterparty to secure a certain exchange rate.
But because the contract is for delivery in the future, there is a risk that the exchange rate will be different on the delivery date than the agreed-upon rate. To compensate for this risk, the forward price will include an adjustment known as the carry.
The carry adjustment reflects the difference in interest rates between the two currencies being traded. If the interest rate in the currency being bought is higher than the interest rate in the currency being sold, the carry will be positive. If the interest rate differential is negative, the carry will be negative.
For example, suppose a trader wants to buy Japanese yen in three months` time and the interest rate in Japan is 0.5%, while the interest rate in the US is 1.25%. The carry adjustment would be negative because the trader is buying a currency with a lower interest rate than the currency they are selling.
The carry adjustment can have a significant impact on the price of a forward contract. A positive carry can add to the price of the contract, while a negative carry can reduce the price. Traders need to take the carry into account when deciding whether to enter into a forward contract and when to exit the contract.
In addition to the interest rate differential, other factors can also affect the carry adjustment, such as central bank policies and market expectations. Traders need to stay up-to-date on these factors to make informed decisions about their forward contracts.
In summary, carry adjustment is an important concept in FX forward contracts that reflects the difference in interest rates between the two currencies being traded. Traders need to take the carry into account when entering into and exiting forward contracts, and stay up-to-date on other factors that can affect the carry adjustment.