DEFINITION of 'Carry Trade'

A trading strategy that involves borrowing at a low interest rate and investing in an asset that provides a higher rate of return. A carry trade is typically based on borrowing in a low-interest rate currency and converting the borrowed amount into another currency, with these proceeds either (a) placed on deposit in the second currency if it offers a higher rate of interest, or (b) deployed into assets – such as stocks, commodities, bonds, or real estate – that are denominated in the second currency. Carry trades are strategies that are only appropriate for deep-pocketed entities because of two major risks – the risk of a sharp decline in the price of the invested assets, and the implicit exchange risk when the funding currency differs from the borrower’s domestic currency.

BREAKING DOWN 'Carry Trade'

Currency risk in a carry trade is seldom hedged, because hedging would either impose an additional cost, or negate the positive interest rate differential if currency forwards are used. Carry trades are popular when there is ample risk appetite, but if the financial environment changes abruptly and speculators are forced to unwind their carry trades, this can have negative consequences for the global economy.

For example, the carry trade involving the Japanese yen had reached $1 trillion by 2007, as it became a favored currency for borrowing thanks to near-zero interest rates. As the global economy deteriorated in 2008, the collapse in virtually all asset prices led to the unwinding of the yen carry trade, leading to it surging as much as 29% against the yen in 2008, and 19% versus the US dollar by February 2009.

Have you ever been tempted to take advantage of the 0% cash advance offered by credit card issuers for limited periods, in order to invest in an asset with a higher yield? That’s the siren call of the carry trade.

Many card issuers dangle a 0% interest rate offer for periods ranging from six months to as much as a year, but require a flat 1% “transaction fee” paid up-front. We’ll therefore assume 1% as the cost of funds for an amount of $10,000 that you have borrowed for a one-year period. Assume you invested this borrowed amount in a one-year certificate of deposit that carries an interest rate of 3%. Your carry trade would therefore net you $200 ($10,000 x [3% - 1%]), or 2%.

That’s not a bad return, but suppose you find it too paltry and decide to play the stock market with the objective of making a total return of 10%. Your net return in this case would be 9%, if the markets cooperate and you achieve your targeted return. But what if there’s a sudden market correction and your portfolio is down 20% by year-end, when the credit card cash advance of $10,000 comes due? Your carry trade has gone awry, since you now have a deficit of $2,000.

Taking this example a step further, let’s say that instead of the stock market, you converted the borrowed amount of $10,000 and placed it in an exotic currency (EC) deposit offering you an interest rate of 6%. At year-end, if the exchange rate between the dollar and EC is the same, your return on this carry trade is 5% (6% - 1%). If EC has appreciated by 10%, your return would be 15% (5% + 10%), but if EC depreciates by 10%, your return would be -5% (5% - 10%).

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