What is a Carry Trade and How It Works

Think about it. You borrow money at a low rate and invest that money somewhere that pays you even more. This is the basic idea behind a carry trade. In the financial markets—more specifically, in the world of foreign exchange (Forex), carry trading is common among investors. They will take a loan in a currency that has a low interest rate, then convert that loan into another currency that has a higher interest rate, and they will then invest it.

The return on this investment is called the carry. It is made by taking the interest you earn on your investment in the higher interest rate currency, minus the interest you are paying on the loan in the low interest funding currency. In concept, this is very simple, but many moving parts reside below this concept.

How the Carry Trade Strategy Works

If one is to carry out a carry trade, this is the general process:

1. You take a loan in a currency that has a low interest rate. This is referred to as the funding currency, meaning the currency that is the 'fund' for the trade. Generally, these are from countries that have a very loose monetary policy, resulting in lower interest rates.

2. You convert the borrowed money into another currency—the target or investment currency—which has a greater interest rate.

3. You invest those savings into assets that are denominated in that higher-rate currency. These → might be bonds, bank deposits, or even equities that are yielding at a higher %. It goes by how aggressive the investor wants to take the risk.

4. You will realize the difference between the interest rate on the loan (funding currency) and the interest on the higher-rate currency when you invest the cash you converted. Suppose the global environment stays steady, meaning the interest rate differential is stable and the exchange rate stays somewhat stable (in the example reference). In that case, the difference between the two sides of a carry trade is profit.

5. Ultimately, you either repay the loan or the cash equivalent of that loan (if you converted back). If the exchange rate has moved unfavourably or interest rates have shifted, any profits may be reduced or completely erased.

Carry Trade Examples

A well-known example involves the Japanese yen. For many years, Japan had very low interest rates. An investor could borrow the yen at a very low cost, convert the yen into US dollars (or other higher-yielding currencies), then invest in Treasury bonds, etc., and earn the higher interest. In this case, the carry profit came from the yield differential minus all borrowing/transaction costs.

Another example: borrow Swiss francs, with rates almost at zero, and convert them to a higher-yielding currency (such as Australian or New Zealand dollars). Then, hold the funds in high-interest deposits or bonds from those countries. Over several decades, many traders have engaged in carry trades funded with either the yen or the franc.

Currency Pairs Initiated

When traders use the term carry trades in Forex, there are some currency pairs they routinely use:

• JPY/USD (borrowing in yen, investing in US dollars)

• CHF/XYZ (borrowing in Swiss francs, investing in whatever the higher-yielding currency is)

• AUD/JPY or NZD/JPY (holding an Australian or New Zealand yield funded by cheap yen)

• Emerging market currency pairs with "safe-haven" funding currencies if they have a much greater interest rate yield.

The criteria are frequently: a significant interest rate differential, relative stability (political/economic) at the investment end, decent liquidity in both currencies and transaction costs that are manageable.

But risk and reward are offered

Reward

• Interest rate differential (the "carry" ): This is the primary source of profit. As long as the investment yields much more than the funding currency, Pothier's/charges are low, and he can find a consistent stream of income.

• Potential exchange rate gains: If the investment currency further appreciates in the relative sense compared to the borrowed currency, the added benefit is at the point of conversion back.

• Diversification: For traders and funds holding other traditional assets (stocks, bonds, etc), this provides exposure to currency markets and the yield curves that hedge away risk.

Risk

• Currency risk/exchange rate movement: If the funding currency increases relative to or devalues the investment currency, money could be lost at conversion, effectively offsetting or exceeding interest gains.

• Potential interest movements: an increase in the funding currency's interest rates or a decrease in the investment currency's yields leads to a narrowing or reversal of the original spread. That generally very quickly removes profit margins.

• Volatility/market stress: The carry trades should generally work, work very well, in calm, stable markets. When markets turn jittery, that can commonly lead investors to unwind positions aggressively, usually creating acute losses.

• The cost and leverage: Borrowing certainly isn't a free option! The transaction fees, rollover costs, spreads, and margin. In a lot of ways, margin is often an effective carry trade, which causes "leverage" to magnify gains and losses.

Advantages and Disadvantages of the Carry Trade Strategy

Below is a summary of what makes carry trades appealing—and what makes them dangerous.

When Carry Trades are Effective - and When They are Not

Carry trades work better in certain market conditions:

- Over large and stable interest differentials.

- Low or muted currency market volatility (no panic for investors).

- Robust economic fundamentals in the investment currency’s domicile, and/or

- Stabile or relatively easily predictable Central Bank policy.

Conversely, they do not work well when:

- volatility spikes (geopolitical crisis or political issues), or

- Unexpected policy changes occur (interest rate increases to the funding currency, and/or interest rate decreases to the investment currency).

- In this case, the currency that you borrowed trades at a much higher price than what you anticipated.

Conclusions

Carry trade can feel like free money: you borrow money cheaply, invest for yield, and you keep the difference. But that shiny possibility comes with real risk. Carry trade, when put into place with awareness of interest rate differentials, exchange rate risk, political/economic stability, and costs, is a good investment tool. The same carry trade returns can initially offer stable price appreciation in a somewhat stable environment, but while the gains remain stable, the market quickly changes and creates sizeable losses.

If you are considering engaging in carry trades, think of them/him/her like any investment - do not leverage too much on one opportunity, use risk management (hedging or stop limits), and monitor key economic indicators in proximity to Central banks, and announce that your position monitors. With a clear plan to try to execute your plan, a carry trade is not assured, but can be good and incremental.