“A welcome period of relative stability in global markets has been upended by a sudden plunge in stock prices.” So begins a 2024 World Economic Forum report on the effects of major shifts in carry trades that year. This highlights the often overlooked yet powerful influence of these financial maneuvers on global financial markets.
In general, a carry trade is any strategy where an investor borrows capital at a lower interest rate to invest in assets with potentially higher returns. However, it’s best known for its use in foreign exchange (forex or FX) markets, where it’s defined as borrowing in a low-interest rate currency and investing in higher-yielding assets denominated in another currency, aiming to profit from the spread.
Key Takeaways
- A carry trade is a strategy that involves borrowing at a low interest rate and reinvesting in a currency or financial product with a higher rate of return.
- But much more is involved, including a bias in the market toward higher interest rate currencies that can’t be explained by traditional economic theory.
- Researchers have found that shifts in the carry trade markets are always fast—there’s never a slow changeover of carry trade regimes, upping the stress for anyone investing in this area.
- Because of the risks involved, carry trades are only for experienced investors.
Consider the yen carry trading of the 2000s: It became so popular that it was estimated to account for up to a fifth of the daily turnover in currency markets. With near-zero interest rates, investors borrowed cheaply in Japanese yen and poured money into higher-yielding assets abroad. This massive flow of capital affected exchange rates and influenced asset prices globally.
The 2024 carry trade unwinding serves as a stark reminder that in the interconnected world of global finance, events in one market can rapidly ripple across the globe. In the following sections, we’ll explore the potential benefits and inherent risks of carry trades, their impact on global financial markets, what researchers say about where profits come from in this area, and then use the 2024 market drop as an illustration of the far-reaching effects of these trades.
Understanding Carry Trades
The typical, simple depiction of carry trades as profiting from interest rate differences leaves out how, broadly speaking, this strategy capitalizes on the idea that capital tends to flow toward countries offering higher real returns—that is, interest rates minus the rate of inflation.
This requires some explanation. In practice, most carry traders don’t physically exchange currencies. Instead, they perform their strategy using futures or forward currency markets, where they can borrow (use leverage) to boost their potential returns. When traders look for interest rate differences between countries, these should be reflected in the forward exchange rates because of interest rate parity, a fundamental concept in international finance.
Forward Premium Puzzle
The forward premium puzzle refers to historical data showing that currencies with higher interest rates tend to appreciate against currencies with lower interest rates, contrary to the predictions of interest rate parity. The phenomenon suggests that forward exchange rates are not neutral predictors of future spot rates. This opening creates the prospects for carry trade profits even as it challenges basic economic theory.
Profiting From Forward Bias
And yet it happens as carry traders exploit a persistent market anomaly known as the “forward premium puzzle” or “forward bias.” Despite what interest rate parity predicts, currencies with higher interest rates often appreciate more or depreciate less than the forward rates imply.
Hence, traders aim to gain not just from the interest rate differences but from any deviation between the actual exchange rate movement and what the forward rates predicted. This complexity makes carry trades potentially lucrative and inherently risky, especially since when these markets shift, they do so rapidly.
This brings us to the phenomenon known as “forward bias.” Although the interest rate differential should be (at least theoretically) already priced into the forward exchange rate, researchers and practitioners have noticed that currencies with higher interest rates tend historically to appreciate more than they should against lower-yielding currencies over time. This trend persists as long as the higher-yielding country maintains economic stability and manageable inflation.
What the Research Says About Profits in Carry Trades
For those who wish to dig a bit deeper into this puzzle, it’s good to quickly review what academics and practitioners have said. First, reviewing decades of data on carry trades, they repeatedly find a risk premium, despite efficient market theories leading one to believe that, all things being equal, the tendency for high-interest currencies to appreciate more (or depreciate less) than what interest rate parity would predict shouldn’t exist.
Here are some explanations given for this:
- Risk premia: Investors may demand more to hold certain currencies, beyond interest rate differentials. This could be because of perceived economic or political risks that can’t be priced into simple interest rate differences. However, this is just another way of restating the puzzle, not answering why it exists.
- Central bank policies: Interventions or anticipated policy changes can influence currency demand in ways not captured by interest rates alone.
- Institutional factors: Similarly, large institutions may have specific needs or mandates that cause them to buy or sell currencies in patterns that don’t align with interest rate parity.
- Behavioral factors: Investors engage in herding behavior or overreact to certain types of news, creating persistent biases in currency flows.
- Market microstructures: The way trades are executed and information flows through the market creates persistent patterns in order flow (supply and demand). A 2024 study, updating previous work, makes the vital contribution of showing that forward bias only exists in specific markets (mainly when interest rate differentials are positive) and isn’t a universally applicable rule. This is crucial for investors involved in carry trades to understand.
- Global imbalances: Long-term capital flows because of trade imbalances or investment patterns often put sustained pressure on certain currencies.
- Negative interest rate differentials correlate to crisis periods: When the typically higher interest rate currency goes lower than the other, these tend to be during economic and market crises. At these moments, there tends to be a flight to security, and the forward bias reverses itself.
- When carry trade regimes change, events move fast: Studies find that transitions between positive and negative interest rate differential regimes are frequently abrupt. This implies that, in practice, snap shifts are the rule, not the exception.
The research on carry trades thus highlights the complexity of currency markets and suggests different factors drive currency moves depending on the economic conditions. Together, the data challenges the notion that carry trades consistently explain deviations from interest rate parity, particularly during market stress or when interest rate differentials are negative.
This is crucial to understand for those wanting to navigate the intricacies of international currency markets. Otherwise, you’ll be unready for the forward bias to suddenly reverse itself, with disastrous results if you’re among those unable to get out of the market in time. This brings us to the risks of carry trading.
Carry Trade Risks
The term “unwinding” in the context of the yen carry trade refers to the mass exodus of investors from this once-profitable strategy. Here’s what happens during this process:
- Investors liquidate the assets they bought with borrowed yen, such as U.S. stocks or bonds.
- They use the proceeds to repurchase yen, driving up demand for the Japanese currency.
- Investors settle their yen-denominated debts, closing out their carry trade positions.
This unwinding easily creates a self-reinforcing cycle. As more investors unwind, the yen appreciates further against other currencies. This makes existing carry trades less profitable, prompting more investors to head for the exits. The assets initially bought with borrowed yen face selling pressure, which then trigger broader market declines. The ripple effects of this unwinding demonstrate the interconnectedness of global financial markets and how strategies built on small interest rate differentials can end up having anything but small effects in the broader economy.
Do Geopolitical Risks Affect Carry Trades?
Geopolitical risks, such as political instability, trade tensions, or changes in government policies, impact the success of carry trades. If a country experiences political unrest, a depreciation of its currency is very likely, and this negatively affects carry trades that involve that currency. Investors must stay informed about geopolitical developments and consider these risks when executing carry trades.
Do Central Banks Play Any Role In the Dynamics Of Carry Trades?
As the 2024 Japanese yen unwinding after the BOJ’s moves shows, central banks play a very important role in the dynamics of carry trade. Changes in interest rates alter the attractiveness of certain currencies for carry trading.
What Are the Psychological Factors That Influence Carry Trade Decisions?
Traders can exhibit behavioral biases that impact their decisions. For example, overconfidence can lead traders to underestimate the risks of currency fluctuations or interest rate changes. In addition, the fear of missing out (FOMO or regret avoidance) can drive traders to enter positions before undertaking enough analysis, leading to significant losses.
Bottom Line
Carry trades are sophisticated investment strategies that exploit interest rate differentials between currencies. While potentially lucrative, they carry significant risks because of exchange rate fluctuations and the possibility of sudden market shifts. The 2024 yen carry trade unwinding demonstrates how changes in monetary policy, such as the Bank of Japan’s interest rate hike, can trigger widespread market disruptions.
This strategy’s effectiveness depends on accurate predictions of interest rate changes and currency shifts, making it primarily suitable for experienced traders with deep understanding of forex markets and risk management. Carry trades can lead to significant losses when market conditions change rapidly.
