The carry trade is when an investor borrows money from a currency with a low interest rate and then uses that money to invest in a currency with a higher interest rate.
The difference in the two interest rates is known as the “carry.”
The idea is to profit from this interest rate discrepancy.
This is a good idea as long as the interest rates remain stable and do not change.
Contents
The larger the difference in interest rates, the larger the potential rewards.
The investor earns interest from the high-yielding investment while paying a lower interest rate on the borrowed funds.
However, as with any investment, there is always a risk.
The risk occurs when the low interest that is being borrowed suddenly increases, or if the high interest rate that is being invested starts to decrease, or both.
The trade will become less profitable and could result in a loss as the difference between the two interest rates narrows.
Example Of The Carry Trade
Japan has historically had low interest rates of near zero for decades.
So investors borrow yen at that low rate and then invest in the U.S. Treasury bonds, which yield a much higher interest rate.
One can find the current interest rates of some common nations by looking at TradingEconomies.com.
For example, an investor might borrow millions of yen at an interest rate of 0.1%.
The investor converts the yen into U.S. dollars and invests in U.S. Treasury bonds, yielding 5.5%.
Assuming the exchange rates remain stable, this investment could return 5.4% – the difference between the interest rates of the United States and Japan.
Why not invest directly in U.S. Treasury bonds at 5.5% without borrowing from Japan?
You can if you have the capital.
To make the trade worthwhile, investors need a large sum of money beyond the capital at hand.
Hence, they need to borrow the capital.
What Could Go Wrong With The Carry Trade?
Continuing with our example:
In late July and early August 2024, the Bank of Japan announced an interest rate increase to stabilize the yen.
The interest rate went from 0.1% to 0.25%.
This rate increase caused Japan’s Nikkei and Topix (Japan’s stock market indexes) to close down more than 12%.
This, plus expectations of the United States lowering its interest rate, caused carry trade investors to sell their U.S. investments to pay off their borrowed yen.
Many believed that this was one of the causes of the U.S. stock market sell-off on August 5th,
2024, where the VIX spiked to over 60.
Covered Carry Trade
To reduce the exchange rate risk, some investors purchase hedges by entering into a forward contract to lock in an exchange rate for the future.
This strategy (known as the “covered carry”) eliminates the risk of exchange rate fluctuations.
However, the hedge cost eats into the potential profits compared to an uncovered carry trade.
Final Thoughts
The carry trade is a trade on interest rates prevalent in the Forex (foreign exchange) market.
But it can be applied to other asset classes as well.
All goes well when the market environment is stable, and the interest rates are not likely to change.
When it is not, then not so well.
Because there is no central location where carry trades are recorded, it is difficult to know how large the carry trade is globally.
The general consensus is that the carry trade represents a significant portion of global capital flows.
The carry trade is often leveraged with the investor using borrowed money to make money.
This can increase the portfolio’s overall risk because leverage magnifies both potential gains and losses.
We hope you enjoyed this article on the carry trade.
If you have any questions, please send an email or leave a comment below.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
