What is Carry Trade?
A carry trade involves borrowing or selling a financial instrument with a low interest rate, then using it to purchase a financial instrument with a higher interest rate.While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased.
So your profit is the money you collect from the interest rate differential.
Let’s say you go to a bank and borrow $10,000. Their lending fee is 1% of the $10,000 every year.
With that borrowed money, you turn around and purchase a $10,000 bond that pays 5% a year.
What’s your profit? 4% right? The difference between interest rates! By now you’re probably thinking, “That doesn’t sound as exciting or profitable as catching swings in the market.”
However, when you apply it to the spot forex market, with its higher leverage and daily interest payments, sitting back and watching your account grow daily can get pretty sexy.
To give you an idea, a 3% interest rate differential becomes 60% annual interest a year on an account that is 20 times leveraged.
Risks of Carry Trades
Carry trades are only appropriate for deep-pocketed entities because of two major risks: the risk of a sharp decline in the price of the invested assets and the implicit exchange risk when the funding currency differs from the borrower’s domestic currency.
Currency risk in a carry trade is seldom hedged, because hedging would either impose an additional cost, or negate the positive interest rate differential if currency forwards are used. Carry trades are popular when there is ample risk appetite, but if the financial environment changes abruptly and speculators are forced to unwind their carry trades, this can have negative consequences for the global economy.
For example, the carry trade involving the Japanese yen had reached $1 trillion by 2007, as it became a favored currency for borrowing thanks to near-zero interest rates. As the global economy deteriorated in 2008, the collapse in virtually all asset prices led to the unwinding of the yen carry trade, leading to it surging as much as 29 percent against the yen in 2008, and 19 percent versus the US dollar by February 2009.