Key points

  • The carry trade strategy takes advantage of the difference in interest rates between two currencies or financial instruments.

  • The idea is to borrow low-interest currencies and invest in high-interest currencies to make a profit. If exchange rates remain favorable, the trader will earn a carry (i.e. profit from the difference in rates).

  • Although carry trades are profitable, unexpected changes in currency prices or interest rates can cause trades to suddenly become unprofitable. The 2008 financial crisis and the 2024 Japanese monetary policy changes are notable examples of such negative outcomes.

  • Successful use of the carry trade requires a deep understanding of global markets and central bank policies, as well as skills in working with leverage. This tool is more suitable for experienced investors and large institutions.

What is a carry trade?

A carry trade is a strategy of borrowing a currency with a low interest rate and investing in another currency or asset with a higher interest rate to make a profit. The idea is to make money on the difference between the rates of the two assets.

While this strategy is primarily used in the forex market and cryptocurrency trading, it can also be applied to stocks, bonds, and even commodities.

How does carry trade work?

The trader borrows a currency with a low or near-zero interest rate (previously, the Japanese yen was used for this, as it had a low rate for many years). The trader then converts the asset into a currency with a higher interest rate, such as the US dollar. This currency can then be invested in, for example, US bonds or other high-yield assets.

So, if you borrow yen at 0% and invest it in an asset that yields 5.5%, you can earn that 5.5% minus fees and other expenses. You're turning cheap money into more valuable money (assuming exchange rates remain favorable).

Why Investors Use Carry Trade

The carry trade strategy is popular because it offers a stable return on interest rate differences without having to increase the amount invested. It is generally used by large players such as hedge funds and institutional investors who have the tools and skills to manage risk.

Often, investors use leverage in carry trades to borrow more money than they have on hand. This can significantly increase returns, but with the potential gains comes the potential loss.

Examples of the carry trade strategy

One of the most famous examples of a carry trade is the classic yen-for-dollar scheme. For years, investors borrowed Japanese yen and used it to invest in US assets, which paid much higher returns. It was a profitable scheme as long as interest rate differentials remained favorable. However, in July 2024, the yen suddenly appreciated against the dollar (more on that below).

Another popular example involves emerging markets. Investors borrow in low-interest currencies and then invest in higher-yielding assets or emerging market bonds. This strategy can yield high returns, but such trades are very sensitive to global market conditions and investor sentiment. If something goes wrong, the trades can quickly become unprofitable.

Risks of the carry trade strategy

As with any investment strategy, carry trading involves certain risks. The most significant of these is currency risk. If the borrowed currency suddenly becomes more valuable than the currency the trader is investing in, profits could be wiped out or even turned into losses when converted.

Suppose a trader borrowed JPY and bought USD, but the yen has strengthened against the dollar, and there is now a risk of losing money if the yen reverts. Another risk is interest rate changes. If the central bank of the borrowed currency raises its interest rate, the cost of borrowing will increase, which will negatively affect profits. Likewise, profits will fall if the bank of the currency we are investing in lowers its rate.

These risks were particularly acute during the 2008 financial crisis, when many investors suffered heavy losses in carry trades, especially involving the yen. And in 2024, changes in Japan's monetary policy led to a strengthening of the yen, causing many traders to abandon their positions and the market to become volatile.

Influence of market conditions

Carry trades tend to be most effective when the market is calm and optimistic. In stable or bullish conditions, currencies and interest rates do not move much, and investors become more confident.

However, when markets become unstable or economic uncertainty arises, carry trades can suddenly become very risky. In highly leveraged and volatile markets, investors may panic and reverse their decisions, causing large swings in currency prices and even broader financial instability.

In 2024, when the Bank of Japan unexpectedly raised interest rates, the yen jumped in value, causing investors to quickly exit their yen trades. Traders began selling risky assets to pay off yen loans, which not only shook currency markets but also triggered a global sell-off in riskier investments. This was further exacerbated by leveraged positions.

In conclusion

Carry trades are an interesting way to profit from interest rate differences between currencies or assets. However, it is always important to consider the risks, especially in highly leveraged and volatile markets.

Successful carry trade strategies require a solid understanding of global markets, currency movements, and interest rate trends. Because the market can turn against you at any time, carry trades are best suited to experienced investors or large institutions with sufficient resources to manage risk effectively.

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