Carry Trade Strategy Explained

Carry trade strategy is an interest rate arbitrage strategy which aims to take advantage of interest rate differentials between two economies of currencies. With a carry trade strategy, investors borrow or exchange a low interest bearing currency for a higher interest bearing currency to either profit from the difference in interest rates or to fund their investments at a lower cost.

Carry trade strategy is employed by large institutional investors who borrow a higher interest rate currency by selling a lower interest rate currency to profit from the interest rate differential. The funds can then be used to invest either in equities or bonds, or to simply park the money and earn a higher interest rate.

Readers should note that carry trade strategy are not as popular as they were a year or two ago. This is because of normalization of interest rates which leaves little room for longer term carry trade opportunities.

How does carry trade in forex work?

From a trader’s perspective, carry trade strategy is nothing but collecting positive swaps by trading a high and low interest rate currencies. Read more about what is rollover or swap in forex here. A good example of a carry trade can be the USDJPY, where the interest rates for the respective currencies stands at 0.75% and -0.10% respectively.

So when a trader goes long on USDJPY, they buy the U.S. dollar by selling the Japanese yen and thus earn positive swaps or overnight interest on such pairs.

In order to understand how currency carry trade works, let’s look at what’s happening in the spot currency markets.

As the name suggests, spot markets are where securities such as currencies are traded for immediate delivery (unlike futures or forward contracts). Thus, when you buy or sell a currency in the spot markets, you get immediate delivery at the current bid or ask rate.

Therefore, when you go long on USDJPY or buy USDJPY, you are effectively buying U.S. dollar by selling Japanese yen. But where did you get the Japanese yen from in the first place?

It was borrowed!

Thus, the currency carry trade comes into effect. At a -0.10% annual interest rate you are paid some additional money for borrowing the yen in the first place. Now, when you convert the yen to U.S. dollars you are selling the borrowed yen for U.S. dollars.

Assuming that the U.S. short term interest rates was at 0.75%, and if you held the U.S. dollars for a year, you would be getting 0.75% interest. You can then convert your profits from U.S. dollars back to yen (and pay back the yen) and pocket a decent profit.

Why is carry trade so popular?

Interest rates are the first and main reason why investors would want to flock towards a higher yielding currency and thus sell a lower yielding currency. Investing, no matter which way you look at it, is all about looking for the next investment opportunity that can offer higher yields or returns.

The interest rates in return represent the overall state of health for an economy. For example, a growing economy will usually have to battle with higher inflation. Central bankers tend to hike interest rates in order to make borrowing more difficult and thus reduce the flow of money into the economy to cool of soften inflationary pressures.

So, from an investor stand point, if their country’s interest rate is low (as is with most developed economies) they tend to seek greener pastures. This includes parking their funds in the equity markets of higher yielding currencies or even picking up bonds or debt of that particular currency. Because interest rate decisions are not messed with ever so frequently, carry trade strategy proves to a be valuable approach… not just for investors but also for the respective economies which want to attract foreign investment.

A good example of carry trade can be seen from the Fed’s taper announcement around September of 2013. During times of low interest rates and the Fed’s easy money policy it was difficult for investors to get good returns on their money.

Thus investor money flew into hot zones such as India, Brazil, Indonesia where the respective interest rates were much higher and thus proved to be an attractive investment option. However, once the Fed started tapering it QE, the hot money started to flow back into the US on expectations of an interest rate hike.

What are the risks of carry trade strategy?

The more profitable an investment option might seem, the more risky it is and carry trade is not immune to the risks. It is risky for the investor as even a mild shake up of stability, either economic or political can rattle investor nerves which could easily trigger a flight to safety. For the economies, the risk comes from the fact that foreign institutional money can flow out of the country, just as easily as it came in.

When it comes to carry trade, perhaps the best example can be taken from the Yen pairs but with a twist. Because of the BoJ’s low interest rate policy, it was easier to borrow money (the Yen) which could then be used to invest in faster growing markets such as the equities.

This is depicted in the chart below, where we saw the demand for Yen grow, which gradually gave rise to the growth in the US equity markets. Notice how after Bernanke mentioned about ‘tapering’ the QE, investors sold off the Yen to park their cash back into the US bond markets.

USDJPY Vs S&P500 - Carry Trade
USDJPY Vs S&P500 – Carry Trade

Therefore, the risks of carry trade can be summarized as:

  • Differing tax rates
  • Foreign exchange controls
  • Costs of transactions

Is there a carry trade forex strategy?

For currency traders, carry trading often starts and ends with the rollovers and swaps as mentioned earlier in this article. However, with currency volatility depending on a lot more other factors than just interest rates, a simple buy and hold strategy with a high and low yielding interest bearing currency pair cannot always give profits.

The following example shows the USDMXN trade, which makes for an attractive carry trade because of the interest rate differentials.

Mexico interest rates were at 3.25% in December 2015, and rose to 6.25% as of February 2017. In comparison, U.S. interest rates were below 1%. So would you have made profits selling USDMXN?

USDMXN Carry trade strategy backfires
USDMXN Carry trade strategy backfires

You can see in the above example that despite steep hikes in interest rates, USDMXN strengthened 19%, when it should have done the opposite. This example highlights the risks of carry trades and that traders should focus on the macro-economics of carry trade before using such methods.

Watch – Basics of Carry Trade