Carry Trade - Stock Traders Glossary

A carry trade is an investment strategy that involves borrowing money in a currency with a low interest rate and using it to invest in assets denominated in a currency with a higher interest rate. The goal is to profit from the difference between the low borrowing costs and the higher yields on the investments.

How It Works
Borrowing in a Low-Interest-Rate Currency:
The investor identifies a currency with a low-interest rate. For example, historically, the Japanese yen (JPY) has had low interest rates.

Converting to a High-Interest-Rate Currency:
The investor converts the borrowed funds into a currency with a higher interest rate. For instance, the Australian dollar (AUD) might offer higher interest rates.

Investing in Higher-Yielding Assets:
The investor then invests these funds in higher-yielding financial instruments in the high-interest-rate currency, such as government bonds, stocks, or other securities.

Example of Carry Trade
Let's consider a practical example involving the Japanese yen (JPY) and the Australian dollar (AUD):

Borrowing Phase: An investor borrows 1,000,000 JPY from a Japanese bank at an interest rate of 0.5%.
Currency Conversion: The investor converts the 1,000,000 JPY to AUD. Suppose the exchange rate is 1 AUD = 80 JPY, so the investor gets 12,500 AUD.
Investment Phase: The investor invests the 12,500 AUD in Australian government bonds yielding 5% per year.

Calculating the Profit
To calculate the potential profit from this carry trade, we consider the following:

Interest Earned on Investment:
The investor earns 5% annually on the 12,500 AUD investment.
Annual interest earned = 12,500 AUD * 5% = 625 AUD.
Interest Paid on Borrowed Funds:
The investor pays 0.5% interest on the 1,000,000 JPY loan.
Annual interest paid = 1,000,000 JPY * 0.5% = 5,000 JPY.
Convert this interest payment to AUD: 5,000 JPY / 80 = 62.5 AUD.
Net Profit:
Net profit in AUD = Interest earned - Interest paid = 625 AUD - 62.5 AUD = 562.5 AUD.

Fluctuations in exchange rates can affect the returns. For example, if the AUD depreciates against the JPY, converting the investment back to JPY may result in losses.

There are two major risks of carry trades
Interest Rate Risk: Changes in interest rates can impact both borrowing costs and investment returns. If the interest rate in Japan increases or the rate in Australia decreases, the profit margin can be reduced.
Credit Risk: The risk that the issuer of the invested asset (e.g., bonds) may default.

There are two benefits of carry trades
Potential for High Returns: The primary benefit is the potential to earn a higher return from the interest rate differential.
Diversification: Investors can diversify their portfolios by investing in foreign assets.

Carry trades have been popular among institutional investors, including hedge funds and large financial institutions. During periods of stable economic conditions, when exchange rates are relatively predictable, carry trades can be highly profitable.However, during periods of economic volatility, carry trades can lead to significant losses. For example, during the 2008 financial crisis, many investors who had borrowed in yen to invest in higher-yielding currencies faced substantial losses as the yen appreciated sharply.

Carry trades can be a profitable strategy when managed carefully, but they require a thorough understanding of the associated risks, particularly regarding exchange rate movements and interest rate changes.