Key Points

  • The goal of a carry trade is to profit from the interest rate differential between two currencies or financial instruments.

  • The concept is to borrow in a currency with a low interest rate, then invest in another currency with a higher interest rate. If the exchange rate stabilizes, you will get the "carry" (i.e. profit from the difference in interest rates).

  • While carry trades 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 2024 monetary policy changes prove that these trades can be detrimental.

  • Carry trades often require a strong understanding of global markets, central bank decisions, and how to effectively manage leverage. As such, they are more suited to experienced investors or large institutions.

What Is Carry Trade?

Carry trade is a strategy of borrowing money in a currency with a low interest rate and then investing it in another currency or asset that offers a higher yield. The concept is simple: you seek to profit from the difference in interest rates.

This strategy is primarily used in the areas of forex and currency trading, but it can also be applied to stocks, bonds, and even commodities.

How Carry Trade Works

Here’s the general process: You take out a loan in a currency that has a low or near-zero interest rate, such as the Japanese yen (JPY), which has had a low interest rate for years. Then you convert that money into a currency with a higher interest rate, such as the US dollar. Once you have the higher-yielding currency, you invest it in assets such as US government bonds or other assets that provide good returns.

For example, if you borrow yen at 0% interest and invest it in something with 5.5% interest, you will get that 5.5% minus any fees or charges. It is like turning cheap money into more money (as long as the exchange rate is stable).

Reasons Investors Use Carry Trade

Carry trades are popular because they offer a way to earn a steady return from interest rate differentials without requiring the value of the investment to rise. This makes them a favorite among big players like hedge funds and institutional investors who have the tools and knowledge to manage risk.

Investors often use leverage in carry trades. That is, they borrow more money than they actually have. This can make the returns much bigger – but the losses can be just as big if things don’t go as planned.

Contoh Carry Trade

One of the most famous examples of a carry trade is the classic yen-dollar strategy. For years, investors borrowed Japanese yen and then used the money to invest in U.S. assets that offered much higher yields. This was a good deal as long as interest rate differentials remained favorable and the yen didn’t suddenly spike against the dollar – which it did in July 2024 (more on that later).

Another popular example involves emerging markets. Investors borrow in low-yielding currencies and then invest in higher-yielding currencies or bonds from emerging markets. The potential returns can be large, but these trades are highly sensitive to global market conditions and shifts in investor sentiment. If things go south, these trades can quickly turn from profitable to problematic.

Risiko Carry Trade

As with any investment strategy, carry trades have risks. The biggest risk is currency risk. If the borrowed currency suddenly becomes more valuable than the invested currency, your gains could be lost or even turned into losses when you convert back.

For example, if you borrow JPY and buy USD, and the yen strengthens against the dollar, you could lose money when you switch back to yen. Another risk is changes in interest rates. If the central bank of the borrowed currency raises interest rates, the cost of borrowing will go up, which could eat into your profits. Or, if the bank of the invested currency cuts interest rates, your yield will go down.

This risk became particularly pronounced during the 2008 financial crisis when many investors suffered heavy losses on carry trades, particularly those involving the yen. In 2024, changes in Japan’s monetary policy caused the yen to strengthen, leading to a wave of carry trade liquidations and market turbulence​.

Impact of Market Conditions

Carry trades tend to do better when markets are calm and optimistic. In these stable or bullish conditions, currencies and interest rates do not move much, and investors are more willing to take risks.

However, when markets are volatile or there is economic uncertainty, carry trades can become very risky very quickly. In highly leveraged and highly volatile markets, investors may panic and start liquidating their carry trades. This can cause large swings in currency prices and even lead to broader financial instability.

When the Bank of Japan unexpectedly raised interest rates in July 2024, the yen surged, prompting many investors to liquidate their yen carry trades. The result was a flurry of selling of high-risk assets to pay off yen loans that not only rocked currency markets but also triggered a global selloff of riskier investments. The impact was further amplified by leveraged positions.

Cover

Carry trades can be an attractive way to profit from interest rate differentials between currencies or assets. However, it is important to consider the risks, especially in highly leveraged and highly volatile markets.

To successfully execute a carry trade, you need a solid understanding of global markets, currency movements, and interest rate trends. Because carry trades can cost you money if the market changes unexpectedly, they are best suited for experienced investors or institutions with the resources to manage risk effectively.

Further Reading

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