Carry trade is a widely-used trading strategy that involves borrowing in a low-interest-rate currency and investing in a high-interest-rate currency to profit from the interest rate differentials.
This strategy is particularly popular in the foreign exchange market, where traders seek to capitalize on the differences between countries’ interest rates.
Let’s explore the concept of carry trade, its underlying principles, and how traders can implement it in their trading strategies.
What is Carry Trade?
Carry trade is a strategy that aims to profit from the difference in interest rates between two countries.
In forex, carry trade involves borrowing in currencies with low-interest rates (called funding currencies) and investing in those with high-interest rates (the target currencies)
It typically involves borrowing funds in a low-interest-rate currency (called funding currency), converting the funds into a high-interest-rate currency (the target currency), and then investing in assets or depositing the funds in an interest-bearing account in the high-interest-rate currency.
Examples of recently attractive target currencies are the Brazilian real, the South African rand, and the Australian dollar.
Popular funding currencies included most recently the U.S. dollar and historically also the Japanese yen or the Swiss franc.
The central idea behind carry trade is that, by taking advantage of interest rate differentials, traders can earn a profit or “carry” without relying on price movements in the underlying currencies.
This strategy can be particularly attractive in times of low market volatility, as it provides a relatively stable source of income.
Principles of Carry Trade
Carry trade is based on several key principles:
- Interest rate differentials: The foundation of carry trade lies in the differences between countries’ interest rates. Traders seek to borrow in low-interest-rate currencies and invest in high-interest-rate currencies to profit from this differential.
- Currency appreciation: While the primary source of profit in carry trade comes from interest rate differentials, traders can also potentially benefit from currency appreciation. If the high-interest-rate currency appreciates against the low-interest-rate currency, the trader can earn additional profit when they eventually unwind the trade.
- Risk management: Carry trade involves inherent risks, such as currency fluctuations and changes in interest rates. Traders must employ sound risk management techniques to protect their investments and mitigate potential losses.
Implementing a Carry Trade Strategy
A popular carry trade has been to sell Japanese yen and buy higher-yielding currencies such as the Australian dollar and New Zealand dollar.
For example, if you buy the AUD/JPY, then you sell Japanese Yen (which yields 0.00% a year)and buy an equivalent amount of Australian Dollars (which say yields 3.50% a year) simultaneously.
As long as you hold that position you would pay 0.00% interest a year for borrowing Japanese yen, and receive 3.50% a year for holding Australian dollars.
The interest rate differential of that position is +3.50 (3.50% – 0.00%).
So you would receive approximately 3.50% a year on the value of the position, depending on the margin interest charged by the broker and on exchange rate volatility.
Traders can implement carry trade strategies using the following steps:
- Identify suitable currency pairs: First, traders should identify currency pairs with significant interest rate differentials. This typically involves comparing the interest rates of various countries and selecting pairs where one country has a significantly higher interest rate than the other.
- Assess currency stability: In addition to interest rate differentials, traders should consider the stability of the currencies involved in the carry trade. Stable currencies with low volatility are generally preferable for carry trade, as they minimize the risk of currency depreciation eroding the profits from the interest rate differential.
- Execute trades: Once a suitable currency pair has been identified, traders can execute their carry trade by borrowing in the low-interest-rate currency, converting the funds into the high-interest-rate currency, and investing in assets or depositing the funds in an interest-bearing account in the high-interest-rate currency.
- Manage risk: As with any trading strategy, risk management is crucial in carry trade. This can be achieved by setting stop-loss orders, monitoring currency fluctuations, and adjusting the trade size according to the trader’s risk tolerance.
- Monitor and adjust: Traders should continuously monitor their carry trades and the underlying market conditions, adjusting their positions and strategies as necessary. This may involve exiting trades when interest rate differentials narrow or when the risk of currency depreciation increases.
Uncovered Interest Parity
This strategy does NOT work if uncovered interest parity (UIP) holds.
The UIP condition states that higher-yielding currencies will tend to depreciate against lower-yielding ones at a rate equal to the interest differential so that expected returns are equalized in a given currency.
Under UIP, any interest differential is expected to be fully offset by currency movements.
A large body of empirical literature documents that UIP fails almost universally at short- and medium-term horizons.
In many cases, the relationship is precisely the opposite of that predicted by UIP: currencies with high-interest rates tend to appreciate while those with low-interest rates depreciate.
This failure of UIP is so well established that the phenomenon is called the “forward premium puzzle”.
The failure of UIP is no secret to investors, hence the popularity of carry trades.
The carry trade puts upward pricing pressure on target currencies and downward pressure on funding currencies.
This could result in the amplification of the underlying exchange rate moves.
In addition, it may also result in more rapid exchange rate moves when carry trade investors unwind their positions.