Carry trade
Family VII · Market & styles
Not to be confused with trade, trade forex.
Carry trade is a strategy that seeks to profit from the difference in interest rates between two currencies. It involves borrowing in a currency with a relatively low interest rate and using the proceeds to buy a currency with a relatively higher interest rate. The trader earns the interest rate differential, but the position is exposed to adverse exchange rate movements.[1]
Mechanics
The trade is typically executed in the foreign exchange market, often with leverage. The trader sells the low-yielding currency (the funding currency) and buys the high-yielding currency (the target currency). The interest earned on the target currency is offset by the interest paid on the funding currency, leaving a net positive carry if the differential is favourable. Profits or losses also arise from changes in the exchange rate between the two currencies.
Worked example
Assume a trader borrows 1,000,000 Japanese yen (JPY) at an annual interest rate of 0.1% and converts it to US dollars (USD) at an exchange rate of 110 JPY per USD, receiving approximately 9,090.91 USD. The USD is invested at an annual interest rate of 2.0%. After one year, the interest earned on USD is 181.82 USD, and the interest owed on JPY is 1,000 JPY (0.1% of 1,000,000). If the exchange rate remains 110 JPY/USD, the interest owed in USD is about 9.09 USD, giving a net profit of 172.73 USD. However, if the JPY appreciates to 100 JPY/USD, the repayment of 1,001,000 JPY would cost 10,010 USD, resulting in a loss.
Risks
The primary risk is exchange rate depreciation of the target currency against the funding currency, which can quickly erase the interest rate differential. Carry trades are also sensitive to changes in interest rates and market volatility. Leverage amplifies both gains and losses. Additionally, sudden unwinding of carry trades can lead to sharp currency movements.
Often confused with
- trade
- A carry trade is a specific strategy that exploits interest rate differentials, whereas a trade is any purchase or sale of a financial instrument; the visible sign is that a carry trade always involves two currencies and an interest rate differential.
- trade forex
- A carry trade is a type of forex trade that focuses on earning interest rate differentials, while trade forex refers to the general activity of trading currency pairs; the visible sign is that a carry trade explicitly involves borrowing one currency to buy another for the interest rate spread.
See also
References
- ↑ Policy rate publications of the relevant central banks. Overnight financing follows the interest-rate differential between the two currencies, plus the broker's own markup, so the figure is not fixed.