The currency carry trade is a strategy in which a trader sells a currency that is offering lower interest rates and purchases a currency that offers a higher interest rate.
In other words, you borrow at a low rate, and then lend at a higher rate.
The trader using the strategy captures the difference between the two rates.
When highly leveraging the trade, even a small difference between two rates can make the trade highly profitable.
Along with capturing the rate difference, investors also will often see the value of the higher currency rise as money flows into the higher-yielding currency, which bids up its value.
Example of currency carry trade
Real-life examples of a Japanese Yen carry trade can be found starting in 1999, when Japan decreased its interest rates to almost zero.
Investors would capitalize upon these lower interest rates and borrow a large sum of Japanese Yen.
The borrowed Japanese Yen is then converted into U.S. Dollars, which are used to buy U.S. Treasury bonds with yields and coupons at around 4.5-5%.
Since the Japanese interest rate was essentially zero, the investor would be paying next to nothing to borrow the Japanese Yen and earn almost all the yield on the U.S. Treasury bonds.
But with leverage, you can greatly increase the return.
Increase the volume with Leverage
For example, 10 times leverage would create a return of 30% on a 3% yield.
If you have $1,000 in your account and have access to 10 times leverage, you will control $10,000.
If you implement the currency carry trade from the example above, you will earn 3% per year.
At the end of the year, your $10,000 investment would equal $10,300, or a $300 gain.
Because you only invested $1,000 of your own money, your real return would be 30% ($300/$1,000).
However this strategy only works if the currency pair’s value remains unchanged or appreciates.
Therefore, most currency carry traders look not only to earn the interest rate differential, but also capital appreciation.
The key thing to remember is that a small difference in interest rates can result in huge gains when leverage is applied.
Most currency brokers require a minimum margin to earn interest for carry trades.
Carry trade is longer-term strategy
However, this transaction is complicated by changes to the exchange rate between the two countries.
If the lower-yielding currency appreciates against the higher-yielding currency, the gain earned between the two yields could be eliminated.
The major reason that this can happen is that the risks of the higher-yielding currency are too much for investors, so they choose to invest in the lower-yielding, safer currency.
Because carry trades are longer-term in nature, they are susceptible to a variety of changes over time, such as rising rates in the lower-yielding currency, which attracts more investors and can lead to currency appreciation, diminishing the returns of the carry trade.
This makes the future direction of the currency pair just as important as the interest rate differential itself.