What is a 'Currency Carry Trade'
A currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.
BREAKING DOWN 'Currency Carry Trade'As for the mechanics, a trader stands to make a profit of the difference in the interest rates of the two countries as long as the exchange rate between the currencies does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, he can stand to make a profit of 10 times the interest rate difference
The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, the trader runs the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.
Currency Carry Trade Calculations Example
As an example of a currency carry trade, assume that a trader notices that rates in Japan are 0.5% while in the United States they are 4%. This means the trader expects to profit 3.5%, which is the difference between the two rates. The first step is to borrow yen and convert it into dollars. The second step is to invest those dollars into a security paying the U.S. rate. Assume the current exchange rate is 115 yen per dollar and the trader borrows 50 million yen. Once converted, the amount that he would have is:
U.S. dollars = 50 million yen / 115 = $434,782.61
After a year invested at the 4% U.S. rate, the trader has:
Ending balance = $434,782.61 x (1 + 4%) = $452,173.91
Now, the trader owes the 50 million yen principal plus 0.5% interest for a total of:
Amount owed = 50 million yen + (50 million yen x (1 + 0.5%)) = 50.25 million yen
If the exchange rate stays the same over the course of the year and ends at 115, the amount owed in U.S. dollars is:
Amount owed = 50.25 million yen / 115 = $436,956.52
The trader profits on the difference between the ending U.S. dollar balance and the amount owed which is:
Profit = $452,173.91 - $436,956.52 = $15,217.39
Notice that this profit is exactly the expected amount: $15,217.39 / $434,782.62 = 3.5%
If the exchange rate moves against the yen, the trader would profit more. If the yen gets stronger, the trader will earn less than 3.5% or may even experience a loss.