What Is Carry Trade?
A carry trade is an investment strategy where an investor borrows money in a currency with a low interest rate (the funding currency) and uses those funds to invest in another currency or asset that offers a higher interest rate (the investment currency). The goal is to profit from the difference in interest rates, known as the interest rate differential, while potentially benefiting from favorable exchange rate movements.
Key Takeaways
- A carry trade involves borrowing in a low-interest-rate currency and investing in a higher-interest-rate currency or asset to profit from the interest rate differential.
- It is widely used in forex but can apply to other asset classes.
- The strategy relies on stable exchange rates and favorable interest rate spreads.
- Carry trades carry significant risks, especially from currency fluctuations and leverage.
- Popular carry trades have historically involved borrowing Japanese yen to invest in higher-yielding currencies like the US dollar.
How Carry Trade Works
- The investor borrows in a low-yielding currency, such as the Japanese yen, which often has near-zero or negative interest rates.
- The borrowed funds are converted into a higher-yielding currency, like the US dollar or Australian dollar.
- The investor earns the interest rate spread between the two currencies, minus any transaction costs.
- Profits can also come from appreciation of the higher-yielding currency relative to the funding currency.
- For example, borrowing Japanese yen at close to 0% interest and investing in US dollars earning 5% interest allows the investor to capture the 5% interest rate differential, adjusted for costs and exchange rate changes.
Applications Beyond Forex
While carry trades are most common in currency markets, the strategy can also apply to other assets. Investors may borrow in a low-interest currency and invest in higher-yielding assets such as stocks, bonds, or cryptocurrencies denominated in a different currency.
Risks of Carry Trade
- Exchange Rate Risk: If the funding currency appreciates against the investment currency, the cost to repay the loan increases, potentially wiping out interest gains.
- Market Volatility: Sudden shifts in interest rates or currency values can lead to significant losses.
- Leverage Risk: Carry trades often use leverage, amplifying both gains and losses.
- Changing Monetary Policies: Central bank rate changes can reduce or eliminate the interest rate differential.
Popular Carry Trades
- The Japanese yen has historically been a popular funding currency due to Japan’s long-standing low interest rates. Investors borrow yen cheaply and invest in currencies like the US dollar, Australian dollar, or New Zealand dollar, which offer higher yields.
- Carry trades can be lucrative when market conditions are favorable but require careful risk management and understanding of global interest rate dynamics and currency movements.