What Is a 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. Generally, the proceeds would be deposited in the second currency if it offers a higher interest rate. The proceeds also could be deployed into assets such as stocks, commodities, bonds, or real estate that are denominated in the second currency.
- The risk of a sharp decline in the price of the invested assets
- The implicit exchange risk, or currency risk, when the funding currency differs from the borrower’s domestic currency
- A carry trade is a trading strategy that involves borrowing at a low-interest rate and re-investing in a currency or financial product with a higher rate of return.
- Because of the risks involved, carry trades are appropriate only for investors with deep pockets.
- A good example of a carry trade is when you accept a credit card that offers a 0% cash advance in order to invest the borrowed cash in assets with a higher yield. This carry-trade strategy may net you either a profit or a loss.
Understanding Carry Trades
Have you ever been tempted to take a 0% cash advance offered by credit card issuers for limited periods in order to invest in an asset with a higher yield? This tactic is the siren call of the carry trade.
Many credit card issuers tempt consumers with an offer of 0% interest for periods ranging from six months to as long as a year, but they require a flat 1% “transaction fee” paid up-front. With 1% 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 (CD) that carries an interest rate of 3%. Such a carry trade would result in a $200 ($10,000 x [3% - 1%]) or 2% profit.
Although carry trades can contain potential financial rewards, this strategy can also pose significant risks.
The carry trade strategy is best suited for sophisticated individual or institutional investors with deep pockets and a high tolerance for risk.
The Risks of Carry Trades
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—or contracts that lock in the exchange rate for a time in the future—are used.
For example, by 2007 the carry trade involving the Japanese yen had reached $1 trillion as the yen had become a favored currency for borrowing thanks to near-zero interest rates. But as the global economy deteriorated in the 2008 financial crisis, the collapse in virtually all asset prices led to the unwinding of the yen carry trade. In turn, the carry trade surged as much as 29% against the yen in 2008, and 19% percent against the U.S. dollar by 2009.
Carry trades are popular when there is ample appetite for risk. However, if the financial environment changes abruptly and speculators are forced to carry trades, this can have negative consequences for the global economy.
How a Carry Trade Can Negatively Affect an Investor
Instead of a CD, an investor may decide to invest the $10,000 in the stock market with the objective of making a total return of 10%. In this case, the net return would be 9% if the markets cooperate. But what if there’s a sudden market correction and the investor's portfolio is down 20% by year-end when the credit card cash advance of $10,000 comes due? In this situation, the carry trade has gone awry, and the investor now has a deficit of $2,000 instead of a 9% 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 an interest rate of 6%. At year-end, if the exchange rate between the dollar and EC is the same, the return on this carry trade is 5% (6% - 1%). If the EC has appreciated by 10%, the return would be 15% (5% + 10%). However, if the EC depreciates by 10%, the return would be -5% (5% - 10%).
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