The carry trade is one of the most popular trading strategies in the currency market. Putting on a carry trade involves nothing more than buying a high-yielding currency and funding it with a low-yielding currency. It’s similar to the adage, “Buy low, sell high.”
Key Takeaways
- A currency carry trade is a strategy that involves borrowing from a lower interest rate currency to fund the purchase of a higher interest rate currency.
- A trader uses this strategy in an attempt to capture the difference between the rates, which can be substantial depending on the amount of leverage used.
- The carry trade is one of the most popular trading strategies in the forex market.
- Carry trades come with risks as they’re often highly leveraged and overcrowded.
- Carry trades can go wrong very quickly.
- Carry traders can recognize profit or loss on the value appreciation or depreciation of the currency pair in addition to potentially earning interest.
The Carry Trade
To enter a carry trade, a trader simply needs to buy a currency pair that represents being long a high yielding currency, and being short a low yielding currency. The first step in putting together a carry trade is finding out which currency offers a high yield and which offers a low yield.
The interest rates for most of the world’s liquid currencies are updated regularly on sites like FXStreet. You can mix and match the currencies with the highest and lowest yields.
The Mechanics of Earning Interest
Carry trades will also fail if a central bank intervenes in the foreign exchange market to stop its currency from rising or to prevent it from falling further.
An excessively strong currency could take a big bite out of exports for countries that depend on them. An excessively weak currency could hurt the earnings of companies with foreign operations. The central banks of these countries could resort to verbal or physical intervention to stem the currency’s rise if, for example, the Australian Dollar or the New Zealand Dollar should get excessively strong. Any hint of intervention could reverse the gains in the carry trades.
If Only It Were This Easy!
An effective carry trade strategy doesn’t simply involve going long on a currency with the highest yield and shorting a currency with the lowest yield. The current level of the interest rate is important but the future direction of interest rates is even more important. The U.S. dollar could appreciate against the Australian dollar if the U.S. central bank raises interest rates at a time when the Australian central bank is done tightening.
Carry trades only work when the markets are complacent or optimistic.
Uncertainty, concern, and fear can cause investors to unwind their carry trades.
When a Carry Trade Goes Wrong
Carry trade comes with many risks. As recent events show, it can take just one of its many moving parts to mishap for the entire trade to unravel.
Through the 2010s and into the 2020s, the Japanese Yen has been a go-to instrument for those trading carry. The country’s negative interest rates policy made it a great currency to borrow, while rising rates in many other developed economies made the potential carry trade only more compelling. For years the traders had exploited the rate differential between the Yen and its counterparts including the U.S. dollar, the Australian dollar, and the New Zealand dollar.
It all began to change in March of 2024, when the Bank of Japan raised its short-term policy rate to 0%-0.10%, ending nearly eight years of negative rates. Then, a few short months later, came a real shocker: on July 31st, 2024 the BoJ raised the rate again, to 0.25%, a level not seen since 2008.
The Japanese yen jumped against the U.S. dollar. The already struggling USD/JPY pair plunged from around 155 to under 142 in a matter of days in a cascade of liquidations – traders closing their positions created additional pressure for the dollar, forcing even more traders to liquidate.
What may look like a relatively small change, a 0.25% rate adjustment in one central bank’s policy, ended up unwinding years of USD/JPY trading.
The Best Way to Trade Carry
An effective way to lower the risks of a carry trade is to diversify your portfolio. Create a basket of a few currencies that yield high, and a few that yield low. That way, a failure of one of the currency pairs involved will not result in a wipeout of your entire portfolio.
This is the preferred way of trading carry for investment banks and hedge funds. The strategy may be a bit tricky for individuals because trading a basket requires greater capital, but it can be accomplished with smaller lot sizes. The key with a basket is to dynamically change the portfolio allocations based on the interest rate curve and the monetary policies of the central banks.
Benefiting From the Carry Trade
The carry trade is a long-term strategy that’s far more suitable for investors than traders. Investors will be happy if they only have to check price quotes a few times a week rather than a few times a day. Carry traders, including the leading banks on Wall Street, will hold their positions for months if not years at a time. The cornerstone of the carry trade strategy is to get paid while you wait.
How Do You Profit From Carry Trades?
Investors earn interest on the currency pair held in a foreign exchange carry trade. The currency pair may move in either direction. You’ll earn the capital appreciation in addition to interest If the pair moves in your favor. You’ll recognize a capital loss if the pair moves adversely.
What Are the Best Carry Trade Currencies?
Currency values, exchange rates, and prevailing interest rates are always fluctuating so no single currency is always best. The most popular carry trades generally involve buying pairs with the highest interest rate spreads.
Is Carry Trading Profitable?
The theory behind carry trading is to borrow one asset to buy another. You’ll remain in a profitable position as long as the interest you’re charged to borrow one asset is less than the interest you’ll receive for the asset you buy. Either currency may fluctuate in value and change your position, however. Trading fees or administrative costs can also impact your profitability.
How Do You Hedge a Carry Trade?
Natural carry trades are unhedged so investors can hedge their position by purchasing options. You can use options to limit potential losses, should a currency significantly fluctuate against you.
The Bottom Line
A carry trade is a popular forex strategy where traders attempt to take advantage of differences in interest rates between currencies. Although these differences may be small, carry trades are often executed with significant leverage in an effort to enhance profitability. While carry trades can work for prolonged periods, they may unwind abruptly if the underlying economic conditions change. Investors interested in carry trading need to study the mechanics of the trade, follow the economic trends of the underlying nations, and only enter a position once they’re confident they understand all the risks.
