We have looked at what it is, how to use it, and its difference with arbitrage. You go to a bank and borrow $10,000 and the bank charges you a 1% interest rate per year. You then use the borrowed funds and invest in a bond that returns 5% per year. Investors earn interest on the currency pair held in a foreign exchange carry trade. You’ll earn the capital appreciation in addition to interest If the pair moves in your favor. Uncertainty, concern, and fear can cause investors to unwind their carry trades.
Still, traders can easily benefit by carefully following central banks make decisions. Therefore, participants in the market use the carry trade strategy by borrowing a currency of a low-yielding country and buying those from higher-yielding countries. A simple definition of a carry trade is that it is a way of trading that involves borrowing a low-yielding currency and investing in high-yield currencies. The yen carry trade has been supported by a seemingly endless supply of ZIRP-enabled currency to borrow and Japan’s commitment to keeping the currency from rising in order to maintain its export economy.
Federal Reserve often engaged in aggressive monetary stimulus which results in low fxcm canada review interest rates. These banks will use monetary policy to lower interest rates to kick-start growth during a time of recession. As the rates drop, speculators borrow the money and hope to unwind their short positions before the rates increase.
Why Is This Strategy So Popular?
Investors must stay informed about geopolitical developments and consider these risks when executing carry trades. One of the main differences is that the carry trade strategy allows traders beaxy exchange review to make profitable trades even when the market is (relatively) stable and has low volatility. As a retail investor, you probably won’t participate in a carry trade—but when big traders are forced to unwind their deals, it can roil global markets, and you’ll want to be ready.
Central Bank Risk
Many people are jumping onto the carry trade bandwagon and pushing up the value of the currency pair. Similarly, these trades work well during times of low volatility since traders are willing to take on more risk. As long as the currency’s value doesn’t fall — even if it doesn’t move much, or at all — traders will still be able to get paid.
- It all started with a small rate hike by the BoJ (from a range below 0.1% to roughly 0.25%) and a promise by the central bank that there would be more hikes to come.
- If a country experiences political unrest, a depreciation of its currency is very likely, and this negatively affects carry trades that involve that currency.
- The central banks of funding currency countries such as the Bank of Japan (BoJ) and the U.S.
Currency Carry Trade Example
Remember, after a carry trader borrows yen, they sell that yen to buy dollars, pounds, or other currency, depending on where they plan to invest. In any country, interest rates are a function of the economics within that country. If the exchange rate fluctuates due to inflation or other economic uncertainties such as civil unrest, drought, or political instability, the market will demand a higher interest rate to compensate.
The yen shot up nearly 10% versus the dollar and other major currencies. At one point on August 5, Japan’s benchmark Nikkei 225 was down about 20% from the previous day (see figure 1). The mini-panic spilled over into the U.S. and sent stocks to their worst single-day move since the early days of the COVID-19 pandemic in 2020. 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. That’s the chief risk of the carry trade—and any trade that’s backed by borrowed money (i.e., leveraged or “on margin”).
Do Geopolitical Risks Affect Carry Trades?
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.
Contrary to popular depictions, carry traders don’t simply buy high-yield currencies and sell low-yield ones. Instead, they use the forward markets, often using significant leverage. Until recently, a popular carry trade involved selling the Japanese Yen against the Australian or New Zealand dollar. Between 2016 and 2024, the Bank of Japan maintained negative interest rates, making the yen a great currency to borrow and fund high-yielding currencies like AUD and NZD.
The cornerstone of the carry trade strategy is to get paid while you wait. 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. Also, carry trades only work when the markets are complacent or optimistic.
The carry trade is one of the most popular trading strategies in the forex market. The most popular carry trades have involved buying currency pairs like the Australian dollar/Japanese yen and New Zealand dollar/Japanese yen because the interest rate spreads of these currency pairs have been quite high. The first step in putting together a carry trade is to find out which currency offers a high yield and which one offers a low yield.
A common question is on the difference between carry trade and arbitrage. The main difference is that carry trade is a form of arbitrage because it takes advantage of the spread between interest rates. Second, while carry trade is a relatively safe trading approach, ensure that you use minimal leverage. This is because being overleveraged can cost you a lot of money if the trades don’t perform as expected. Another example of carry trade is what happens in interest rates between the United States and Japan. Before the coronavirus crisis, the Federal Reserve had hiked interest rates to more than 2.5%.
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. In August 2024, global financial markets experienced significant volatility, with the S&P 500 index falling 3%—its largest single-day drop in almost two years. While many factors contributed to this decline, including disappointing economic data, the unwinding of the Japanese yen carry trade soon emerged as a key reason.