Currency Carry Trade: Definition as Trading Strategy and Example
What is a Currency Carry Trade?
A currency carry trade is a strategy whereby a high-yielding currency funds the trade with a low-yielding currency. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.
The carry trade is one of the most popular trading strategies in the forex market. The most popular carry trades have involved buying currency pairs like the Australian dollar/Japanese yen and New Zealand dollar/Japanese yen because the interest rate spreads of these currency pairs have been quite high. The first step in putting together a carry trade is to find out which currency offers a high yield and which one offers a low yield.
The currency carry trade is one of the most popular trading strategies in the currency market. Consider it akin to the motto "buy low, sell high." The best way to first implement a carry trade is to determine which currency offers a high yield and which offers a lower one.
The most popular carry trades involve buying currency pairs like the AUD/JPY and the NZD/JPY, since these have interest rate spreads that are very high.
Mechanics of the Carry Trade
As for the mechanics, a trader stands to make a profit of the difference in the interest rates of the two countries as long as the exchange rate between the currencies does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, he can stand to make a profit of 10 times the interest rate difference.
The funding currency is the currency that is exchanged in a currency carry trade transaction. A funding currency typically has a low interest rate. Investors borrow the funding currency and take short positions in the asset currency, which has a higher interest rate The central banks of funding currency countries such as the Bank of Japan (BoJ) and the U.S. Federal Reserve often engaged in aggressive monetary stimulus which results in low-interest rates. These banks will use monetary policy to lower interest rates to kick-start growth during a time of recession. As the rates drop, speculators borrow the money and hope to unwind their short positions before the rates increase.
When to Get in a Carry Trade, When to Get Out
The best time to get into a carry trade is when central banks are raising (or thinking about) interest rates. Many people are jumping onto the carry trade bandwagon and pushing up the value of the currency pair. Similarly, these trades work well during times of low volatility since traders are willing to take on more risk. As long as the currency's value doesn't fall — even if it doesn't move much, or at all — traders will still be able to get paid.
But a period of interest rate reduction won't offer big rewards in carry trades for traders. That shift in monetary policy also means a shift in currency values. When rates are dropping, demand for the currency also tends to dwindle, and selling off the currency becomes difficult. Basically, in order for the carry trade to result in a profit, there needs to be no movement or some degree of appreciation.
KEY TAKEAWAYS
- A currency carry trade is a strategy whereby a high-yielding currency funds the trade with a low-yielding currency.
- A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.
- The carry trade is one of the most popular trading strategies in the forex market.
Currency Carry Trade Example
As an example of a currency carry trade, assume that a trader notices that rates in Japan are 0.5 percent, while they are 4 percent in the United States. This means the trader expects to profit 3.5 percent, which is the difference between the two rates. The first step is to borrow yen and convert them into dollars. The second step is to invest those dollars into a security paying the U.S. rate. Assume the current exchange rate is 115 yen per dollar and the trader borrows 50 million yen. Once converted, the amount that he would have is:
U.S. dollars = 50 million yen ÷ 115 = $434,782.61
After a year invested at the 4 percent U.S. rate, the trader has:
Ending balance = $434,782.61 x 1.04 = $452,173.91
Now, the trader owes the 50 million yen principal plus 0.5 percent interest for a total of:
Amount owed = 50 million yen x 1.005 = 50.25 million yen
If the exchange rate stays the same over the course of the year and ends at 115, the amount owed in U.S. dollars is:
Amount owed = 50.25 million yen ÷ 115 = $436,956.52
The trader profits on the difference between the ending U.S. dollar balance and the amount owed, which is:
Profit = $452,173.91 - $436,956.52 = $15,217.39
Notice that this profit is exactly the expected amount: $15,217.39 ÷ $434,782.62 = 3.5%
If the exchange rate moves against the yen, the trader would profit more. If the yen gets stronger, the trader will earn less than 3.5 percent or may even experience a loss.
Risks and Limitations of Carry Trades
The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, the trader runs the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.
An effective carry trade strategy does not simply involve going long a currency with the highest yield and shorting a currency with the lowest yield. While the current level of the interest rate is important, what is even more important is the future direction of interest rates. For example, the U.S. dollar could appreciate against the Australian dollar if the U.S. central bank raises interest rates at a time when the Australian central bank is done tightening. Also, carry trades only work when the markets are complacent or optimistic. Uncertainty, concern, and fear can cause investors to unwind their carry trades. The 45% sell-off in currency pairs such as the AUD/JPY and NZD/JPY in 2008 was triggered by the Subprime turned Global Financial Crisis. Since carry trades are often leveraged investments, the actual losses were probably much greater.
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