Imagine borrowing money in Japan, where interest rates are near zero, and investing it in Australia, where the interest rates are over 4%. This is the essence of a carry trade—a strategy that has been used by traders to profit from the difference in interest rates between countries. But how does this seemingly simple strategy work in practice, and what are the risks?
‘Carry trade’ is an interesting and popular tactic in the foreign exchange (forex) markets, where traders borrow money in a currency with a comparatively low interest rate and use it to invest in a currency with a higher interest rate.
Think of it like borrowing dollars at a low cost and then investing them in Australian dollars or South African rand, which might offer higher returns because of their higher interest rates.
As long as the trade continues and the circumstances stay favourable, the trader benefits.
What is Carry Trades and How it Works?
In a carry trade, a trader borrows funds in a currency that has a low interest rate (referred to as the funding currency) and uses them to invest in an asset or currency that has a higher interest rate (referred to as the target currency or asset).
Making money off of the interest rate differential, or “carry,” is the aim. Although it can be applied to other assets like equities or bonds, this approach is most frequently used in the foreign exchange (FX) market.
For instance, to purchase U.S. dollars, which may have a higher interest rate, an investor can borrow Japanese yen at a very low interest rate. The investor then earns the interest rate differential, which amounts to a return on holding the trade, provided the exchange rates don’t move unfavourably.
Although carry trades can be profitable, there are a number of dangers involved, particularly with regard to currency rate swings and shifts in central bank regulations. When markets are stable, this strategy can generate steady earnings, but when market conditions change rapidly, carry trades can lead to sharp losses.
In short, a carry trade involves “borrowing cheap to invest in something more expensive” to make a profit from the interest rate gap between two currencies or assets.
At its most basic, a carry trade involves several key steps:
- Selecting a Funding Currency: This is the currency with a low interest rate, often stable and considered a “safe haven.” Examples include the Japanese yen (JPY) or the Swiss franc (CHF).
- Funding Currency Borrowing or Short Selling: The trader short sells or borrows this low-yielding currency.
- Buying a Higher-Interest Currency: The borrowed funds are used to buy a currency that offers a higher interest rate, such as the Australian dollar (AUD), the New Zealand dollar (NZD), or even emerging market currencies like the South African rand (ZAR).
- Holding the Position: The trader receives the interest rate differential, also referred to as the positive carry or swap, as long as the position is open.
Often, traders gear up with leverage to amplify returns, borrowing more than their original capital allows. While this can multiply profits, it also dramatically elevates the risk since even small adverse movements in the exchange rate can cause sizable losses.
Positive vs. Negative Carry
There are two main flavours of carry trades:
- Positive Carry: When the currency you buy has a higher interest rate than the one you borrow. You earn interest daily, effectively receiving a “bonus” while holding the position.
- Negative Carry: The reverse scenario, in which you pay interest every day because the currency you purchase has a lower interest rate than the one you sell. Negative carry trades are only made by traders who believe that price changes will offset the interest payment.
Why Are Carry Trades So Popular?
Carry trades appeal for several reasons:
- Potential for Passive Income: Holding a position with a positive interest differential means earning interest regularly without needing to actively buy or sell.
- Favourable in Stable Markets: These trades thrive when markets are calm, as low volatility reduces the risk of sudden adverse currency swings wiping out interest earnings.
- Possibility for Additional Gains: Not only do traders earn the interest differential, but if the high-yielding currency appreciates against the funding currency, they can achieve additional profits.
- Relatively Straightforward Strategy: Compared to more complex trading tactics, carry trades are conceptually simple and can be held over weeks or months for steady returns.
Risks of Carry Trades
Despite their allure, carry trades harbour inherent risks that can quickly turn a profitable position sour:
- Interest Rate Risk: Central banks constantly adjust interest rates based on economic conditions. If the low-interest funding currency’s central bank raises rates, or the high-interest target currency’s central bank cuts rates, the interest differential narrows or disappears, eroding profits.
- Exchange Rate Risk: This is perhaps the biggest threat. Should the funding currency unexpectedly strengthen against the target currency, it can obliterate gains. For example, if a trader borrowed Japanese yen but the yen appreciates sharply against the Australian dollar, losses can mount.
- Market Sentiment Shifts and Crowded Trades: Carry trades can become crowded as many traders flock to the same strategy. A sudden change in sentiment can lead to rapid unwinds, driving violent exchange rate swings.
- Volatility and Liquidity: Carry trades typically suffer when market volatility spikes or liquidity dries up. In crises, traders rush to unwind positions, causing liquidity black holes where selling snowballs, worsening price moves.
- Emerging Market Risks: Emerging currencies, often targets due to higher rates, can also face sudden devaluations caused by political instability or hyperinflation.
- Leverage Amplification: Leverage can boost profits but also magnifies losses. A small move against a leveraged position may trigger margin calls.
- Economic and Geopolitical Shocks: Unforeseen events—like elections, wars, or economic crises—can cause swift currency movements that derail carry trades.
Managing the Risks
Savvy traders employ several methods to manage carry trade risks:
- Setting Stop Loss and Take Profit Orders: These predefined exit points help limit losses or secure gains amid market swings.
- Monitoring Central Bank Policies Carefully: Interest rate announcements and economic data releases are crucial to anticipate shifts in the carry trade environment.
- Keeping Leverage in Check: Overleveraging is a common pitfall. Moderate leverage keeps exposure manageable.
- Diversifying Carry Positions: Instead of putting all eggs in one basket, traders can spread risk by engaging in multiple carry pairs or combining with other strategies.
- Using Hedges: Advanced traders may use options, futures, or cross-currency strategies to hedge against adverse movements.
The Role of Central Banks
Central banks are the key puppeteers behind carry trades. They determine the interest rate landscapes through monetary policy. When a central bank raises rates, it often attracts capital flows and strengthens the currency, making carry trades into that currency attractive.
Conversely, rate cuts or shifts towards easing pressure can undermine carry trade profitability. Sharp or unexpected policy changes often trigger the rapid unwinding of carry trades, resulting in significant market volatility.
The Japanese Yen Carry Trade
One of the most famous carry trades involved the Japanese yen in the early 2000s. Japan had persistently low-interest rates, so investors borrowed cheap yen to invest in higher-yielding currencies like the Australian dollar or emerging market assets.
By 2007, this “yen carry trade” grew so massive it was estimated to constitute nearly a fifth of daily forex trading volume worldwide. But when the 2008 financial crisis hit, risk appetite evaporated overnight.
Investors rushed to unwind their yen carry trades, leading to a sharp appreciation of the yen – its value surged by around 29% against typical target currencies during 2008 and kept rising into 2009.
Fast forward to 2024, a similar pattern emerged. The Bank of Japan’s unexpected rate hike to combat inflation surprised global traders, triggering a rapid unwinding of yen carry trades.
The surge in yen demand and fall in riskier assets like U.S. stocks caused global market turbulence, underscoring how interconnected and impactful carry trades can be.
Carry Trades vs. Arbitrage
It’s important to distinguish carry trades from arbitrage. Arbitrage exploits price inefficiencies to lock in risk-free profits quickly across different markets.
Meanwhile, carry trades are time-dependent, relying on interest rate gaps and currency movement, inherently exposing traders to market risk.
Carry trades are not risk-free arbitrage but a speculative strategy seeking to profit from interest rate differentials over time.
The Forward Premium Puzzle
Economic theory predicts that currencies with higher interest rates should depreciate relative to low-interest currencies (due to interest rate parity).
Yet, in practice, high-yield currencies often appreciate more than expected – a phenomenon known as the forward premium puzzle or forward bias.
This anomaly partly explains why carry trading can be profitable, but it also highlights the complexities and nuances in currency markets that challenge textbook economics.
Final thoughts
Carry trades offer a compelling strategy to earn profits from interest rate differentials combined with potential currency appreciation. Sounds like a simple win-win? Not quite. The strategy involves considerable risk: market volatility, central bank surprises, currency swings, and leveraged losses can quickly wipe out gains.
Successful carry traders understand these pitfalls and manage them cautiously through risk controls, diversification, and vigilant monitoring of global economic signals. For those with deep pockets and nerves of steel, carry trades can serve as an effective tool for steady income and capital growth, especially in stable market conditions.
Himani Verma is a seasoned content writer and SEO expert, with experience in digital media. She has held various senior writing positions at enterprises like CloudTDMS (Synthetic Data Factory), Barrownz Group, and ATZA. Himani has also been Editorial Writer at Hindustan Time, a leading Indian English language news platform. She excels in content creation, proofreading, and editing, ensuring that every piece is polished and impactful. Her expertise in crafting SEO-friendly content for multiple verticals of businesses, including technology, healthcare, finance, sports, innovation, and more.
