What is Carry Trade? Definition, Example, Benefits, and Risks
Finance offers a variety of investment strategies, each of which comes with its own set of rewards and risks. Imagine borrowing money at a very low interest rate and using it to invest in an asset that offers higher returns. That is the basic idea behind the carry trade. It helps investors to pocket the difference between the borrowing rate and the investment return.
Today’s blog explores the concept of carry trade, its benefits, the risks involved and how to manage them.
What Is a Carry Trade?
A carry trade is an investment strategy that involves borrowing a low-yield currency to invest in a high-yield currency or asset to generate gains from the difference between the interest rates of two different currencies or assets.
Let us understand how to carry trade works.
Suppose you borrow money denominated in currency A and convert it into currency B, which has a higher interest rate than currency A. The proceeds are used to invest in currency B to earn a higher interest rate. The proceeds could also be invested in other assets denominated in currency B.
The objective of carry trade is to earn a higher interest rate on the investment (currency B) than the interest rate paid on the borrowed money (currency A).
Carry Trade Example
An investor borrows 1000 Japanese Yen at 1% interest to be paid yearly. He then converts the Japanese Yen (JPY) to Australian Dollars (AUD) and invests it in an Australian bond for a year with a 5% rate of return. Assume JPY/AUD = 10.
Amount in AUD = 1000 * (1/10) = AUD 100
The investor invests AUD 100 in an Australian bond at 5%.
After one year, the investor gets AUD 105. The proceeds in AUD need to be converted to JPY.
Amount in JPY = 105 * 10 = JPY 1050
Interest owed = 1% of JPY 1000 = JPY 10
Effectively, the investor earns JPY 50 on an investment of JPY 1000 and owes JPY 10 as interest on the JPY loan.
Net Return = JPY 50 – JPY 10 = JPY 40
The net return of JPY 40 is 4% of the total amount borrowed. 4% is also equal to the interest rate differential.
Benefits of Carry Trades
Carry trade is used by many investors around the globe due to the various benefits it offers. Some of the benefits are listed below:
- Higher Returns: These trades offer the opportunity to earn high returns by taking advantage of differences in currency interest rates. An individual can make money by borrowing at a low interest rate and investing at a high interest rate.
- Increased Portfolio Diversification: Carry trades can add a layer of diversification to your portfolio. Assets denominated in different currencies reduce the risk of a particular currency losing its value.
- Profit without Price Appreciation: Carry trades let an individual make a profit without needing the exchange rate to change, unlike the traditional ‘buy low, sell high’ approach. If the interest rate difference is in favour, an individual will make money.
Risks Involved in Carry Trades
Carry trades come with some inherent and unavoidable risks. Below mentioned are some of the key risks:
- Currency Fluctuations: This is the biggest risk. The complete idea of carry trade depends upon the difference in interest rate between two currencies. If the exchange rate moves against you, you could lose money.
- Interest Rate Changes: Central banks can increase or lower interest rates to control inflation or other economic conditions. In extreme cases, it can wipe off your profits or even cause losses.
- Herd Mentality: When numerous investors enter into the carry trade involving the same pair of currencies, the market can become crowded. When sentiment changes and investors sell their holdings, it can cause sudden and sharp price reversals, leading to big losses.
- Market Volatility: Economic and political events can cause market volatility, impacting interest rates and currency exchange rates.
How to Manage the Risks
Carry trades must be managed with caution, and the following measures can be taken to manage the risks:
- Select a pair of currencies that has a comparatively stable exchange rate.
- Use hedging instruments like currency forwards or options to lessen the risk of adverse currency movements.
- Keep yourself updated about economic and political developments that could affect interest rates and currency exchange rates.
- Reduce the size of your carry trade compared to your overall portfolio to minimise the risk of losses.
Furthermore, the carry trade strategy needs a certain level of risk tolerance, a decent understanding of global economic dynamics, and the ability to analyse trade positions actively.
Conclusion
On a parting note, a carry trade strategy can offer high returns but comes with extensive risks concerning currency and interest rate fluctuations. Successful carry trading needs careful risk management; only then can an individual harness carry trade strategy to enhance their portfolio returns. Carry trades can result in substantial losses, so it is better to consult a financial advisor before investing in a carry trade.
Frequently Asked Questions (FAQs)
What is carry trade?
A carry trade is borrowing money in a low-interest-rate currency and using it to invest in an asset or currency that offers a higher rate. The difference in interest rates is the profit.
What are some alternatives to carry trades?
Apart from carry trades, an individual can invest directly in high-interest-rate bonds or other fixed-income instruments.
What are common funding currencies for carry trades?
Common funding currencies include the Japanese Yen (JPY) and the Swiss franc (CHF) because of their low interest rates.
Can carry trades affect currency markets?
Yes, large-scale carry trades can affect currency valuations and market volatility, especially if many investors unwind their positions simultaneously.
Are carry trades suitable for all investors?
Carry trades are best-suited for experienced investors who understand the risks and can monitor their positions effectively.
