What is the Carry Trade?

Carry trade can be entered by simply finding and selling a low-yielding currency and buying a high-yielding one. 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. To enter a carry trade, a trader simply has to buy a currency pair that represents being long on a high-yielding currency and being short on a low-yielding currency. The first step is determining which currency offers a high yield and which offers a low yield. “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.

The borrowed funds would then be invested in U.S. stocks and Treasury bonds in anticipation of a higher return. The currency carry trade is one of the most popular trading strategies in the forex market. The first and main step in entering a carry trade is to determine which currency offers a high yield and which offers a lower one. Effectively, a carry trade is a return that an investor generates for holding, or carrying, an asset such as a currency or commodity for the death of money book summary by james rickards a period of time.

Swing Trading Signals

To understand why and how carry trade can work in various markets, let’s consider some scenarios with the various markets. Brokers close and reopen your position, and then they debit/credit you the overnight interest rate differential between the two currencies. But when a popular carry trade abruptly stops working, the effects can be widespread.

Costs and Risks Involved

1. The current level of the interest rate is important but the future direction of interest rates is even more important.
2. The currency pair must either not change in value or appreciate for a carry trade to succeed.
3. Investors must stay informed about geopolitical developments and consider these risks when executing carry trades.
4. It’s worth noting that while individual risks might seem manageable, the real danger often lies when several of these occur at once.
5. Now consider that the Bank of Japan has signaled that more rate hikes are possible.

The 2024 market correction triggered by the unwinding of yen-related carry trades was not unprecedented. Carry trades attempt to exploit differences in interest rates from central banks relating to two currencies. In carry trades, investors borrow money in a low-interest-rate currency (the funding currency) and use it to invest in high-yielding assets denominated in another currency (the target currency). Though we’ll complicate this depiction in a moment, how to start a freight brokerage the goal is to profit from the interest rate differential and potential appreciation of the target currency. That could be positive, as is usually the case for cash held in bank accounts, or negative if the asset needs to be stored at a cost (as, say, a barrel of oil does). A carry trade is an attempt to profit from the gap between the yields of a pair of assets, often two currencies that attract different interest rates.

Using leverage to play a carry trade strategy in Forex

The strategy generally involves using leverage to magnify any potential returns. The best time to get into a carry trade is when central banks are raising interest rates, or thinking about raising them. A currency carry trade is a strategy in which traders borrow in a low-interest-rate currency and invest the proceeds in a high-interest-rate currency, aiming to profit from the interest rate differential. The Japanese Yen has been a go-to instrument for those trading carry through the 2010s and into the 2020s. 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. The traders had exploited the rate differential between the Yen and its faithful finance counterparts for years including the U.S. dollar, the Australian dollar, and the New Zealand dollar.

If enough people are crowded into the same bets, sharp movements like this can create a self-reinforcing dynamic. If a position becomes a big enough liability, traders’ risk departments may force them to close it. That means buying back the borrowed currency, which causes it to strengthen even more and sends others’ trades further underwater. This can affect unrelated assets, too, if traders need to sell them for cash to meet their carry-trade losses. Many think that is part of the reason all sorts of prices, from those of Japanese and American shares to gold, plummeted at the start of August. In a currency carry trade, traders borrow in a low-interest-rate currency and invest the proceeds in a high-interest-rate currency.

The yen strengthened by as much as 29% against carry trade currencies in 2008, and the unwinding continued into 2009, with the yen appreciating 19% against the U.S. dollar. However, if the financial environment changes abruptly and speculators are forced to carry trades, this can have negative consequences for the global economy. 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. In the forex market, currencies are traded in pairs (for example, if you buy USD/CHF, you are actually buying the U.S. dollar and selling Swiss francs at the same time). That rate is still very low, of course, and in and of itself not a big deal for the carry trade.

This is unlike covered interest arbitrage whereby the investor uses a forward contract to hedge against exchange rate risks while trying to benefit from the interest rate differential. Given that there was an enormous amount of money involved in this particular carry trade, the unwinding is having massive effects in markets around the world as investors sell stocks and other assets in order to repay those loans. The euro (EUR) and Brazilian real (BRL) pair represents a more volatile but potentially lucrative carry trade. Borrowing in euros, where interest rates have been lower due to the European Central Bank’s monetary policies, and investing in Brazilian assets, which offer high yields, has been an attractive option for risk-tolerant investors.