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Most currency traders must already be familiar with the concept of currency carry trade. However, it is important to understand the risks involved in this form of trading vis-à-vis the high returns that it seems to promise, especially in the context of the fluid forex markets of today.

Currency carry trade involves borrowing money from nations with low interest rates and investing it in nations that yield higher returns. The most popular nation for the purpose of borrowing cheap traditionally has been Japan, where interest rates have been hovering around 0%

Example of currency carry trade

Trader borrows 10,000 Yen at 0% from a Japanese bank
He converts it into US dollars at the exchange rate of 100 Yen = 1 US dollar
He invests US $ 100 in US bonds yielding 4%
At the end of 1 year he earns $4, without paying any interest for his Japanese borrowing
He converts his $104 into Yen and repays the principal with a profit of $4

This example assumes that exchange rate between the yen and the dollar remained the same

This gain can be enhanced by the use of leverage, which allows trading at multiple levels of margin money. Thus if the trader could have used a common leverage factor of 10:1, he could have multiplied his profit to $40 on his borrowing of $100, which is a whopping 40%. If the leverage level is increased to 100:1, the profitability could shoot up to 400%,

Risks to carry trade

As you might have been able to guess, the greatest risk that a carry trade transaction can face is a change in exchange rates. In the example above, if the Yen were to move up to 96 Yen = 1 US dollar, the trader’s entire profit would be wiped out.

The trader would enter into a dangerous position if the exchange rate were to rise to 94 Yen = 1 US dollar. If the trader had leveraged his borrowing by 100:1, his total outstanding to the bank would be 1000,000 Yen.

Illustration of the loss

Trader borrows 1000,000 Yen at 0% from a Japanese bank at the leverage level of 100:1. His own margin money being 10000 Yen
He converts it into US dollars at the exchange rate of 100 Yen = 1 US dollar
He invests US $ 10,000 in US bonds yielding 4%
At the end of 1 year he earns $400 and his total corpus becomes $10400
However, the exchange rate has moved to 94 Yen = 1 US dollar
On converting his corpus of $10400 into Yens, he finds that he is left with 9,77,600 Yen. His loss equals 22400 Yen.

Smart carry trade strategies

While, carry trade can provide opportunities for huge profits, slight swings in the exchange rates can lead to substantial losses, especially when the leverage levels get very high. Smart strategies for carry trade rely upon the intelligent selection of a currency pair. Thus the carry trader’s main focus should be to select a currency pair where the interest differential is sufficiently high and where the carry trader expects favorable movement of exchange rates.

Carry trade as self perpetuating cycle
Carry trade leads to borrowing in low interest currency and then the sale of that currency to buy another currency to invest in the higher yielding nation. Once the virus of carry trading spreads and a large number of traders get involved in it, the continuous selling pressure on the low yield currency exerts a downward pressure on the currency value. This increases profitability for carry traders and encourages greater exposure to carry trade and more borrowing in the low yield currency and its further sale takes place. This becomes a self perpetuating cycle, where increasing carry trade leads to depreciation of the currency, which further attracts more carry trade opportunities!!

The role of economics in carry trade

The strengths of the economies of the respective currency pairs selected can play a key role in the relative movement of exchange rates for the currency pair. If the trader expects that the economy of currency in which he has borrowed is likely to get weaker, then the central bank of that nation may lower interest rates and the currency may weaken further. Assuming the currency in which the trader has invested stays stable, his profits are likely to go up. On the other hand, if the economy of the nation in which the money has been invested is likely to grow and face inflation, the central bank of the nation is likely to increase interest rates. This may cause the currency to appreciate and increase profitability. Thus, carry traders need to evaluate a variety of economic signals and plan out their trading strategies doubly carefully as the double edged sword of leverage can end up being doubly sharp!!