Carry trading using forward contracts

The carry trade is a much simpler process than this makes out and doesn't require FX futures or swaps. Essentially you borrow an amount of money (from the bank, by issuing bonds etc. doesn't matter really) at a low interest rate in one currency, convert the borrowed money to a higher interest rate currency and lend it back out at that rate. After the loan time the borrower pays you back in their country's currency which you convert back into the other currency to pay off the loan you took out. Your profit is the difference.

The problem with doing this is that when the money that you have lent out is repaid it is repaid in the higher interest rate currency but you owe the money in the other currency. This exposes you to FX risk on top of the interest rate risk that you are bearing which you want to mitigate as much as possible. To do so you can lock in the exchange rate for the time when the principal of the loan is to be repaid to you with an FX future or forward for the same underlying currency pair. Since you know when you want to convert the money in the first place an FX swap, which locks in the FX rate for each "leg" - i.e. each time you do an FX conversion, is ideal.

With a locked in future interest rate you forgo the chance that the FX rate will move in your favour for a guaranteed rate in the future. The above analysis is based on zero coupon bonds but extends trivially to coupon bearing bonds - you just have two known cash flows in two currencies at regular intervals so can add futures or swaps to lock in the FX rate at those junctures.