Key aspects
Financial bicycles consist of taking advantage of the difference in interest rates between two currencies or financial instruments.
The idea is to borrow in a currency with a low interest rate and invest in a product with a higher interest rate. If the exchange rate is as expected, you earn what is known as "carry" (the profit from the difference in rates).
While this strategy can be profitable, unexpected changes in currency values or interest rates can quickly turn a good trade into a bad one. The 2008 financial crisis and Japan's monetary policy changes in 2024 are examples of how these trades can go wrong.
Financial bicycles often require extensive knowledge of global markets, central bank decisions and how to manage leverage effectively. They are therefore best suited to experienced investors or large institutions.
What is a financial bicycle?
A financial bicycle or "Carry Trade" is a strategy that consists of borrowing money at a low interest rate to invest it in a currency or asset that offers higher returns. The objective is simple: it seeks to profit from the difference between interest rates.
While this strategy is primarily used in the foreign exchange market and currency trading, it can also be applied to stocks, bonds, and even commodities.
How financial bicycles work
The procedure is usually as follows: you take out a loan in a currency that has low or near-zero interest rates, such as the Japanese yen (JPY), which had low rates for years. Then you convert that money into a currency with a higher interest rate, such as the U.S. dollar. Once you have the higher-yielding currency, you invest in a product, such as U.S. Treasury bonds or other assets that yield a good return.
For example, if you borrow 0% yen and invest it in a product that pays 5.5%, you earn 5.5%, minus any applicable fees or costs. It's like turning cheap money into more money (as long as the exchange rates are convenient).
Why Investors Use the Financial Bicycle Technique
The financial bicycle is a well-known strategy because it offers a way to obtain a constant return on the difference between interest rates, without the need for the value of the investment to increase. This is why it is one of the most popular strategies among large players, such as hedge funds and institutional investors, who have the tools and knowledge necessary to manage the risks.
Investors often use leverage in financial bicycle trading, meaning they borrow much more money than they actually have. This can make profits much bigger, but it also means that losses can be just as big if things don't go as planned.
Examples of financial bicycle operations
One of the best-known examples is the classic yen-dollar strategy. For years, investors borrowed Japanese yen to invest in US assets that offered much higher returns. This was a good deal as long as the interest rate spread remained favourable and the yen did not suddenly rise in value against the dollar, which finally happened in July 2024 (more on that below).
Another popular example involves emerging markets. Here, investors borrow in a low-interest currency and then invest in higher-yielding emerging market currencies or bonds. The potential gains can be great, but these trades are highly sensitive to global market conditions and changes in investor sentiment. If things go wrong, they can quickly go from profitable to problematic.
Risks of financial bicycle operations
As with any investment strategy, financial bicycle trading is not without risk. The biggest of these is currency risk. If the currency you borrowed suddenly becomes more valuable compared to the currency you invested in, you can lose all of your profits and even incur losses when you convert it back.
For example, if you borrow JPY to buy USD and the yen strengthens against the dollar, you could lose money by exchanging it back for yen. Interest rate fluctuations are another risk. If the central bank of the currency you borrowed raises interest rates, your borrowing costs rise and your returns are reduced. Or, if the bank of the currency you invested in cuts rates, your returns decrease.
These risks became very real during the 2008 financial crisis; several investors lost a lot of money in such trades, especially those involving the yen. In 2024, due to changes in Japan's monetary policy, the yen rose in value and triggered a wave of financial bicycle trades and market instability.
The impact of market conditions
Financial bicycle trading works best when the market is calm and optimistic. In these stable or bullish conditions, currencies and interest rates do not fluctuate too much and investors are more willing to take risks.
However, when the market becomes unstable or there is economic uncertainty, these types of trades can become very risky, very quickly. In highly leveraged and volatile markets, investors can panic and begin to liquidate their financial bicycle positions, which can lead to large swings in currency prices and even cause global financial instability.
When the Bank of Japan unexpectedly raised interest rates in July 2024, the value of the yen soared and many investors quickly closed out of yen financial bicycle trades. The result was a rush to sell riskier assets to repay yen loans, which not only shook currency markets but also triggered a sell-off of riskier investments globally. The impact was amplified by leveraged positions.
Conclusions
Financial bicycle trading can be an interesting way to profit from interest rate differences between currencies or assets. Still, it is important to be aware of the risks, especially in highly leveraged and volatile markets.
To be successful with this type of trading, you need to have a thorough understanding of global markets, currency movements, and interest rate trends. Since they can all come back to haunt you if the market changes unexpectedly, financial bicycle trading is best suited for experienced investors or institutions that have the resources to manage the risks effectively.
Further reading
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