What Is a Negative Carry Pair?
A negative carry pair is the foundation of the negative carry trade. A negative carry pair is a foreign exchange (forex) trading strategy in which the trader borrows money in a high-interest currency and invests it in a low-interest currency.
A trader would only initiate this strategy if they were bullish on the low-interest rate currency, believing that it will appreciate relative to the high-interest rate currency. This is because the net amount of interest they need to pay to maintain the position exceeds their interest income, making it costly to carry. As such, it is the opposite of the far more popular positive carry pair, which forms the basis of the carry trade.
- A negative carry pair is the basis for forex transactions involving speculation on the appreciation of a high-interest-bearing currency.
- It is the opposite position of the far more popular positive carry trade strategy.
- Negative carry pairs incur negative net cash flows, making them relatively expensive to maintain over time.
Understanding Negative Carry Pairs
The negative carry pair is a forex trading strategy that seeks to exploit differences in the exchange rate and interest rates associated with different currencies, where it is effectively the reverse of the more popular carry trade strategy.
To initiate a negative carry pair, the trader borrows money in a currency in which interest rates are higher, and then invests those proceeds in another currency with lower interest rates. This means that, upon initiating the position, the trader will actually incur negative net cash flows because their interest expenses on the short currency exceed their interest income on the long side. By contrast, the traditional carry trade involves taking the opposite position: borrowing in the low-interest currency and investing in the high-interest one, in order to generate positive net cash flow on day one.
A trader would only initiate the negative carry trade if they believed that the low-interest currency in which they are investing will appreciate relative to the high-interest currency in which they are borrowing. In that scenario, the trader would profit when they reverse out of the initial trade: selling the currency they invested in in exchange for the currency they borrowed in, then repaying their debt and pocketing the gain on the transaction. Of course, this potential gain would need to exceed the cost of the interest payments made throughout the term of the investment in order for the entire transaction to be a success.
Real World Example of a Negative Carry Pair
To illustrate, suppose you are a forex trader keeping a close eye on the global currency market. You observe that there is a 1:1 exchange rate between Country X and Country Y, and that interest rates in Country X are 4%, compared to 8% in Country Y. You also believe that Xs, the currency of Country X, will likely appreciate relative to Ys, the currency of Country Y.
With this in mind, you decide to structure a position whereby you can profit from the anticipated appreciation of Xs relative to Ys. To accomplish this, you begin by borrowing 100,000 Ys. Because their interest rate is 8%, you need to pay 8,000 Ys per year in interest.
Your next step is to invest this money in Xs. Because they have a 1:1 exchange rate, you sell 100,000 Ys and obtain 100,000 Xs. Because the interest rate on Xs is 4%, you receive 4,000 Xs per year in interest. Therefore, your net cashflow position upon initiating the trade is -4,000 Ys per year (4,000 Xs Interest Income – 8,000 Ys Interest Expense, assuming a 1:1 exchange rate).
Over the course of the next year, your prediction comes true and the X appreciates by 50% relative to the Y. Therefore, you are able to sell your 100,000 Xs in exchange for 150,000 Ys. You then repay your loan of 100,000 Ys. After deducting your net interest expense of 4,000 Ys, you are left with a profit of 46,000 Ys on the transaction (150,000 Ys – 100,000 Y Loan – 4,000 Y Net Interest Expense).
Of course, if the X had not appreciated relative to the Y, then you would have lost at least as much as your net interest expense. If the X had instead depreciated relative to the Y, your losses could have climbed significantly higher.