What is a Currency Carry Trade
A currency carry trade is a strategy whereby a high-yielding currency funds the trade with a low-yielding currency. 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.
Currency Carry Trade
BREAKING DOWN Currency Carry Trade
The currency carry trade is one of the most popular trading strategies in the currency market. Consider it akin to the motto "buy low, sell high." The best way to first implement a carry trade is to determine which currency offers a high yield and which offers a lower one.
The most popular carry trades involve buying currency pairs like the AUD/JPY and the NZD/JPY, since these have interest rate spreads that are very high.
Mechanics of the 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.
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 percent, while they are 4 percent in the United States. This means the trader expects to profit 3.5 percent, which is the difference between the two rates. The first step is to borrow yen and convert them 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 percent U.S. rate, the trader has:
Ending balance = $434,782.61 x 1.04 = $452,173.91
Now, the trader owes the 50 million yen principal plus 0.5 percent interest for a total of:
Amount owed = 50 million yen x 1.005 = 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 percent or may even experience a loss.
Risks of Carry Trade
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.
When to Get in a Carry Trade, When to Get Out
The best time to get into a carry trade is when central banks are raising (or thinking about) interest rates. Many people are jumping onto the carry trade bandwagon and pushing up the value of the currency pair. Similarly, these trades work well during times of low volatility since traders are willing to take on more risk. As long as the currency's value doesn't fall — even if it doesn't move much, or at all — traders will still be able to get paid.
But a period of interest rate reduction won't offer big rewards in carry trades for traders. That shift in monetary policy also means a shift in currency values. When rates are dropping, demand for the currency also tends to dwindle, and selling off the currency becomes difficult. Basically, in order for the carry trade to result in a profit, there needs to be no movement or some degree of appreciation.