What Is Carry Trade?
A carry trade is 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 proceeds placed on deposit in the second currency if it offers a higher rate of interest or deploying proceeds into assets – such as stocks, commodities, bonds, or real estate – that are denominated in the second currency.
Risks of Carry Trades
Carry trades 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.
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 percent against the yen in 2008, and 19 percent versus the US dollar by February 2009.
How Carry Trades Work
Have you ever been tempted to take a 0 percent 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 credit card issuers dangle a 0 percent interest rate offer for periods ranging from six months to as much as a year, but they require a flat 1 percent “transaction fee” paid up-front. With 1 percent as the cost of funds for a $10,000 cash advance, assume an investor invested this borrowed amount in a one-year certificate of deposit that carries an interest rate of 3 percent. Such a carry trade would result in a $200 ($10,000 x [3 percent - 1 percent]) or 2 percent gain.
Instead of the CD, an investor may instead decide to invest the $10,000 in the stock market with the objective of making a total return of 10 percent. Net return, in this case, would be 9 percent, if the markets cooperate. But what if there’s a sudden market correction and the portfolio is down 20 percent by year-end when the credit card cash advance of $10,000 comes due? In such a situation, the carry trade has gone awry, and the investor now has a deficit of $2,000 instead of a 9 percent gain.
Taking this example a step further, let’s say that, instead of the stock market, the investor converted the borrowed amount of $10,000 and placed it in an exotic currency (EC) deposit offering you an interest rate of 6 percent. At year-end, if the exchange rate between the dollar and EC is the same, your return on this carry trade is 5 percent (6% - 1%). If EC has appreciated by 10 percent, your return would be 15 percent (5 percent + 10 percent), but if EC depreciates by 10 percent, the return would be -5 percent (5 percent - 10 percent).