What is Carry Trade?
Historically, popular carry trade pairs have involved borrowing in low-interest currencies like the Japanese yen (JPY) or Swiss francs (CHF) to invest in higher-interest currencies such as the U.S. dollar (USD), Mexican peso (MXN) or Australian dollar (AUD). The choice of currencies varies based on global economic conditions and monetary policies.
Although some individual investors participate in carry trades, they are more commonly used by large institutional investors, hedge funds, and forex traders with the tools to manage the associated risks.
Warning: The carry trade strategy is most suitable for experienced individual or institutional investors with substantial financial resources and a high tolerance for risk.
How Carry Trades Work
Here’s how carry trade works:
You borrow money in a currency with low or almost zero interest rates—like the Japanese yen, which has had low rates for a long time. You then exchange that money for a currency with a higher interest rate, such as the US dollar. With this higher-yielding currency, you invest in something like US government bonds or other assets that offer a solid return.
For instance, if you borrow yen at 0% interest and invest it in something that pays 5.5%, you earn that 5.5% minus any fees or costs. If the exchange rates stay favorable, it’s like making more money from borrowed money.
Why Investors Use Carry Trades
Carry trades are popular because they allow investors to earn a steady return from the difference in interest rates without relying on the investment’s value increasing. This makes them a favored strategy among major players like hedge funds and institutional investors, who have the expertise and resources to handle the associated risks.
For instance, an investor might borrow Japanese yen (JPY) at a 0.1% interest rate to purchase U.S. Treasury bonds yielding 4%. As long as exchange rates remain stable, the profit comes from the 3.9% difference.
Investors frequently use leverage in carry trades, allowing them to borrow significantly more money than they actually possess. This can significantly increase the potential returns, but it also means the losses can be just as large if things don’t go as expected.
Examples of Carry Trades
A well-known example of a carry trade is the yen-dollar strategy. For many years, investors borrowed Japanese yen and invested that money in US assets with much higher returns. This worked well as long as the interest rate difference remained favorable and the yen didn’t suddenly increase in value against the dollar—which eventually did happen in July 2024 (but more on that later).
Another common example is in emerging markets. In this case, investors borrow in a low-interest currency and invest in higher-yielding currencies or bonds from emerging markets. The potential returns can be impressive, but these trades are very sensitive to global market conditions and changes in investor sentiment. If the market is downturned, what started as a profitable trade can quickly become risky and troublesome.
How to make a carry trade?
To make a carry trade, follow these steps:
- Identify the Interest Rate Differential: Find two currencies with a significant interest rate difference. Typically, you would borrow in a currency with a low interest rate and invest in a currency with a higher interest rate.
- Borrow in the Low-Interest Currency: Take out a loan or use leverage to borrow the currency with the lower interest rate. For example, you might borrow Japanese yen (JPY) if the interest rate in Japan is low.
- Convert to the High-Interest Currency: Exchange the borrowed currency for one with a higher interest rate. For example, you might convert the borrowed yen into Australian dollars (AUD) if Australia’s interest rates are higher.
- Invest in High-Yield Assets: Use the high-interest currency to invest in assets that offer a return, such as government bonds, stocks, or even holding the currency itself to earn interest.
- Monitor and Manage Risks: Monitor the exchange rates, interest rate changes, and any geopolitical or economic factors that might affect the trade. Currency fluctuations can impact your returns, so managing these risks carefully is crucial.
- Close the Trade: When you decide to exit the trade, convert the high-interest currency back to the low-interest currency, repay the borrowed amount, and pocket the difference as profit.
This strategy works best when the exchange rates are stable or move in your favor and when the interest rate differential remains significant. However, it’s important to be aware of the risks, including potential currency depreciation and changes in interest rates.
Risks of Carry Trades
Like any investment method, carry trades comes with risks. The biggest risk is related to currency changes. If the currency you borrowed becomes stronger than the one you invested in, your profits can disappear, or you might even lose money when you change it back.
For example, if you borrow Japanese yen (JPY) and buy US dollars (USD), but then the yen strengthens against the dollar, you could lose money when you convert back to yen. Another risk is interest rate changes. If the central bank of the currency you borrowed raises interest rates, your borrowing costs increase, which can reduce your profits. Similarly, if the central bank of the currency you invested in lowers rates, your returns could decrease.
These risks became apparent during the 2008 financial crisis, when many investors suffered significant losses on carry trades, particularly those involving the Japanese yen (JPY). In 2024, changes in Japan’s monetary policy led to a stronger yen, sparking a wave of carry trade unwinding and resulting in market turbulence.
The Impact of Market Conditions
Carry trades generally perform well when the market is calm and optimistic. In these stable or bullish conditions, currencies and interest rates are relatively steady, and investors are more inclined to take on risk.
However, when the market becomes unstable or there’s economic uncertainty, carry trades can quickly become risky. In highly leveraged and volatile markets, investors may panic and start unwinding their carry trades, leading to significant fluctuations in currency prices and potentially causing broader financial instability.
When the Bank of Japan unexpectedly raised interest rates in July 2024, the yen (JPY) surged, prompting many investors to quickly unwind their yen carry trades. This caused a rush to sell higher-risk assets to repay yen loans, disrupting currency markets and leading to a global sell-off of riskier investments. The situation was made worse by many investors’ leveraged positions, amplifying the impact.
What is the Most Popular Carry Trade?
The most popular carry trade historically has been the yen carry trade, where investors borrow Japanese yen (JPY) at very low interest rates and invest in higher-yielding currencies or assets, such as the Australian dollar (AUD) or U.S. dollar (USD). The popularity of the yen carry trade stems from Japan’s long-standing low-interest-rate environment, making it an attractive currency to borrow against in order to capitalize on the interest rate differentials.
Investors profit from the difference between the low borrowing costs in yen and the higher returns from the investment in the higher-yielding currency or asset, provided the exchange rate remains favorable.
The Gap Between Theory and Practice in Carry Trades
The common, straightforward explanation of carry trades as a way to profit from interest rate differences overlooks the broader concept that this strategy takes advantage of the tendency for capital to flow toward countries offering higher real returns—meaning the interest rate adjusted for inflation.
This concept needs a bit of clarification. In reality, most carry traders don’t exchange currencies. Instead, they use futures or forward currency markets, which allow them to borrow and leverage their positions to potentially increase returns. When traders seek out interest rate differences between countries, these differences are typically reflected in forward exchange rates due to interest rate parity, a key principle in international finance.
Tip: Financial reporters often describe carry trades as “a cost-free source of profit.” However, if such a risk-free or cost-free profit opportunity existed in the broader market, it wouldn’t stay under the radar for long—word would quickly spread.
Interest rate parity suggests that the difference in interest rates between two countries should be mirrored in the forward exchange rates between their currencies. For example, if the U.S. has higher interest rates than Japan, the forward exchange rate for USD/JPY should be higher than the spot rate (the current market price) to account for that difference.
In theory, adjustments in the forward or futures markets should prevent risk-free arbitrage—profiting by buying and selling an asset simultaneously in different markets without risk. If you could simply borrow in a low-interest currency, convert to a high-interest currency, invest at a higher rate, and then use a forward contract to eliminate exchange rate risk, everyone would jump on it. However, the forward rate is designed to adjust and make this kind of risk-free profit impossible—at least in theory.
The forward premium puzzle refers to historical evidence showing that currencies with higher interest rates often appreciate relative to currencies with lower interest rates, which goes against the expectations set by interest rate parity. This phenomenon indicates that forward exchange rates are not unbiased predictors of future spot rates. As a result, it creates opportunities for carry trade profits, even though it contradicts fundamental economic theory.
Profiting From Forward Bias
Despite what interest rate parity predicts, carry traders exploit a market anomaly known as the “forward premium puzzle” or “forward bias.” This occurs because currencies with higher interest rates often appreciate more or depreciate less than forward rates suggest. Traders aim to profit not only from interest rate differences but also from deviations between actual exchange rate movements and what forward rates predict. This makes carry trades potentially lucrative and risky, especially since market shifts can happen quickly.
The “forward bias” persists because currencies with higher interest rates tend to appreciate more than expected, assuming the country maintains economic stability and manageable inflation. Traders don’t just buy high-yield currencies; they use leverage and forward markets to profit from discrepancies between actual exchange rate changes and those implied by forward rates. This strategy relies on exploiting inefficiencies where theoretically no profit should exist, particularly in stable and high-yielding markets.
Closing Thoughts
Carry trades are advanced investment strategies that capitalize on interest rate differences between currencies or assets. While they can be highly profitable, they also carry significant risks due to exchange rate volatility and sudden market shifts. The 2024 yen carry trade unwinding, triggered by the Bank of Japan’s interest rate hike, is a prime example of how changes in monetary policy can lead to major market disruptions.
Success in carry trades requires a deep understanding of global markets, currency fluctuations, and interest rate trends. Given the potential for rapid changes in market conditions and the associated risks, this strategy is best suited for experienced investors or institutions with the resources and expertise to manage these risks effectively.
FAQs
What Are the Psychological Factors That Influence Carry Trade Decisions?
Traders can be influenced by behavioral biases that affect their decision-making. For instance, overconfidence may cause them to underestimate the risks of currency fluctuations or interest rate changes. Additionally, the fear of missing out (FOMO) can push traders to enter positions without sufficient analysis, potentially leading to significant losses.
Do Central Banks Play Any Role In the Dynamics Of Carry Trades?
The 2024 Japanese yen unwinding following the Bank of Japan’s actions highlights central banks’ critical role in the dynamics of carry trades. Changes in interest rates can significantly influence the appeal of certain currencies for carry trading, making central bank policies a key factor to monitor.
Do Geopolitical Risks Affect Carry Trades?
Geopolitical risks, including political instability, trade tensions, or shifts in government policies, can significantly impact the success of carry trades. If a country faces political unrest, its currency is likely to depreciate, which can adversely affect carry trades involving that currency. Therefore, investors must stay informed about geopolitical developments and consider these risks when carry trades.
Is carry trade profitable?
Carry trades can be highly profitable under favorable conditions, as Reuters highlights. For example, the interest rate gap between the US and Japan has enabled investors to potentially earn annual returns of 5% to 6% on dollar-yen carry trades.
What is an example of a carry trade in forex?
An example of a carry trade in forex involves borrowing in a currency with a low interest rate, such as the Japanese yen (JPY), and using that borrowed money to buy a currency with a higher interest rate, like the Australian dollar (AUD).
For instance, suppose the interest rate in Japan is 0.1%, and in Australia, it’s 4%. A trader might borrow yen at a low interest rate and convert it to Australian dollars, then invest those AUD in an Australian asset or simply hold the currency, benefiting from the higher interest rate. The profit comes from the difference between the low cost of borrowing yen and the higher returns from holding the AUD, as long as the exchange rate remains stable or moves in the trader’s favor.
How do I measure carry trade activity?
Measuring carry trade activity is crucial for understanding market trends, potential risks, and opportunities. Various indicators and tools can be used to gauge the extent of carry trade activity, helping investors and analysts make informed decisions.
Here are some common methods to measure carry trade activity:
- Interest Rate Differentials: The difference in interest rates between two currencies is a key driver of carry trades. A wider differential often indicates more carry trade activity.
- Currency Exchange Rates: Monitoring the exchange rates of popular carry trade currency pairs can provide insights into whether carry trades are active.
- Speculative Positioning Data: Reports like the Commitment of Traders (COT) show traders’ net positions, which can signal the level of carry trade engagement.
- Risk Reversals and Options Pricing: Option markets can reveal market sentiment toward currency pairs, indicating carry trade activity when traders hedge against risks.
- Carry Trade Indices: Some indices track the performance of a basket of carry trade currencies, offering a direct measure of carry trade activity.
- Capital Flows Data: Analyzing capital flows into high-yielding currencies can indicate active carry trades.
- Volatility Measures: Carry trades are more attractive in low-volatility environments, so monitoring market volatility can also provide clues about carry trade activity.
By understanding and monitoring these indicators, investors can better assess the state of carry trade activity in the market.