Carry trade strategy in forex is very common, but can be applied in other investment areas as well. In general terms, it consists of taking advantage of differences in interest rates.
Today, it is also considered a financial tool with great potential to generate additional profits. Therefore, in this article, we will explore what the carry trade is, what it means, and introduce you to a series of illustrative examples for better understanding.
What is the carry trade strategy?
A carry trade is a financial strategy where an investor borrows money at a low interest rate and then invests that money in an asset that provides a higher return.
Suppose there's a country (Country A) where interest rates are very low, say 1%. An investor borrows money in that country's currency at this low rate. The investor then converts this borrowed money into the currency of another country (Country B) where the interest rates are higher, say 5%. They invest this money in a safe asset in Country B, like government bonds, which pays the higher interest rate. The investor profits from the difference in interest rates – in this case, 4% (5% earned in Country B minus 1% paid in Country A).
This strategy is commonly employed in forex. Suppose an investor borrows 100,000 US dollars (USD) with a low interest rate of 1% and then exchanges them for 110,000 Japanese yen (JPY) with an interest rate of 3%.
If at the end of the investment period, the exchange rate between the USD and the JPY remains stable, the investor will have profits thanks to the difference in interest rates. At the end of the period, the investor returns the 100,000 USD and keeps the 110,000 JPY, making a profit of 1,000 JPY.
However, carry trade also comes with risks. If the exchange rate between the two currencies fluctuates unfavourably, the investor could suffer losses instead of profits.
What is the purpose of the carry trade strategy?
If you analyse the concept of the carry trade, you will understand that it is a strategy that pursues a clear objective: to generate profits by taking advantage of differences in interest rates between two currencies or assets. In this technique, as we already explained, an investor acquires borrowed funds in a currency with low interest to then invest them in another currency or asset with higher interest rates or returns.
Role of carry trade in the forex market
The carry trade strategy enjoys great popularity in the forex market. As explained, it allows traders to take advantage of disparities in interest rates between different currencies.
In this scenario, the trader pays lower interest rate for the borrowed currency while receiving returns from the higher interest rate of the bought currency.
The difference between both rates is known as the interest rate differential. Essentially, the carry trade involves borrowing money at a low cost in a country with a reduced interest rate and then investing it in currency with a higher interest rate.
Within an ideal context, an example of carry trade would be the following:
- Borrow money in the United Kingdom and pay only a 0.10% interest for it.
- Invest those funds in Brazil, where a 2% interest would be received.
- The resulting net gain would be 1.90% (2% – 0.10%).
Even so, remember that this example is simplified and in reality, the interest rates that are paid or received can vary and be subject to high volatility, as well as additional commissions and costs from the banks or brokers used.
How does the carry trade work?
- Identification of the appropriate currency pair: The investor selects a currency pair with an opportunity to carry out a successful carry trade.
- Borrow the low interest rate currency: The investor borrows the currency with the lowest interest rate and pays interest on the loan.
- Convert the borrowed currency into the high interest rate currency: The investor converts the borrowed currency into the currency with the highest interest rate and receives interest on the invested money.
- Maintain the position: The investor maintains the position as long as the interest rates remain favourable to profit from the interest rate difference.
- Close the position: The investor closes the position when the interest rates are no longer favourable or when they decide to take profits.
What factors should be considered when using a carry trade strategy?
- Interest rates: The most important factor in carry trade is the difference in interest rates between the two currencies involved. A greater difference in interest rates means there is a greater potential for profits.
- Economic stability: It is important to monitor the economic conditions of the countries whose currencies are being traded. Economic conditions, inflation reports, GDP growth, and unemployment levels can affect interest rates and therefore the value of currencies in the long term.
- Market volatility: Financial markets are volatile and can fluctuate quickly, which can affect the profitability of a carry trade position. It is important to monitor market volatility indicators and have a solid risk management strategy to protect capital.
- Monetary policy: The monetary policies of central banks directly affect interest rates and therefore the value of currencies. It is important to be aware of announcements, and decisions of central banks and consider how they can affect our positions in the market.
- Transaction costs: It is important to consider transaction costs, such as exchange costs and interest on loans. These costs can significantly reduce profits and should be considered in any profitability analysis.
What other types of assets are used with a carry trade strategy?
The carry trade can be applied to different types of financial assets, although it's most commonly applied to the foreign exchange market (forex). However, it can also be used with many other assets, including:
- Stock market: An investor might borrow money at a low interest rate and invest in high-dividend-paying stocks or stock funds. The idea is to earn more from the dividends than the cost of the interest on the borrowed money.
- Bonds: Similar to the forex example, an investor could borrow money at low interest rates and buy bonds that pay higher yields in another market. This could involve buying corporate bonds, municipal bonds, or even government bonds of different countries.
- Real estate: Investors could use a carry trade strategy by taking a mortgage with a low interest rate to buy property. The property could then be rented out or developed, with the aim of generating returns that are higher than the mortgage interest.
- Commodities: This involves borrowing money to invest in commodities like gold, oil, or agricultural products. The hope is that the price increase in these commodities will exceed the cost of borrowing.
Anyway, regardless of the type of asset used in the carry trade, keep in mind all the associated risks, such as changes in interest rates, market movements, and political or economic risks.
What are the types of carry trade?
There are several types of carry trade strategies:
- Classic carry trade: This is the most straightforward form of carry trade. An investor borrows money in a currency with a low interest rate and invests in a currency with a higher interest rate. The profit is the interest rate differential, assuming exchange rates remain favorable.
- Leveraged carry trade: This involves using borrowed capital (leverage) to amplify the investment. While it can significantly increase potential returns, it also greatly increases risk, as losses can exceed the initial investment.
- Reverse carry trade: In this scenario, an investor does the opposite of the classic carry trade – they borrow in a high-interest currency and invest in a low-interest currency. This is less common and typically employed in anticipation of a significant appreciation in the low-interest currency or a steep decline in the high-interest currency.
- Option-based carry trade: This strategy uses options trading to manage the risk associated with carry trades. An investor might use currency options to hedge against unfavourable movements in exchange rates, potentially limiting losses.
Example of carry trade strategy
If you want to learn how carry trade works, let's analyse the following example:
To understand the difference or interest rate differential, let's consider the interest rates of the central banks of Canada and Mexico. Thus, the carry trade would develop as follows:
- Borrow money in Canada with an interest of only 1.75%.
- Invest that money in Mexico, where an interest of 7.25% would be obtained.
- The net profit would be the difference between the interest rates: 7.25% – 1.75% = 5.5%.
This is a simplified example of carry trade, as the interest rates that are paid or received will depend on the size of the investment, as well as the commissions and costs of the bank or broker used.
It should be noted that the foreign exchange market (forex) is ideal for carry trade operations since currencies are traded in pairs. For example, when buying the EUR/USD currency pair, you acquire the euro while simultaneously selling US dollars.
How is the return on carry trade calculated?
Now, you have probably heard or wondered how the return on carry trade is calculated. The answer is simple and uses the same principle as in the previous calculation. We will explain it with another example, to visualise what the difference is or the differential of the interest rate, for which we are going to take as reference the interest rate of the central banks of the United States and Chile.
So the carry trade would be:
- Borrow money in the UK, and pay 4.50% interest on it.
- That money is invested in Chile, where it would receive an 11.25% interest.
- The net gain would be the difference in the interest rate: 11.25% – 4.50% = 6.75%
Leverage in carry trade: examples
Leverage can be used to amplify the potential for profits (but also losses). In itself, it enables the possibility to borrow additional capital to increase the size of the position.
Moreover, by resorting to leverage, you can access larger funds to invest in a high-interest currency, which potentially increases profits in relation to your own capital. However, it also increases the risk, as losses are also amplified.
In summary, leverage can allow investors to assume larger positions in the carry trade with less of their own capital. For example, if an investor has a capital of $10,000 and uses a leverage of 1:10, they could invest up to $100,000 in a transaction.
How can you evaluate if carry trade is a good investment option at a given time?
- Exchange rate volatility: Exchange rate volatility is a significant risk in any carry trade strategy. Changes in the value of currencies can reduce or even eliminate the profits obtained from the interest rate differential. It is important to evaluate the historical and expected volatility of the exchange rate to determine if the carry trade is an appropriate strategy at a given time.
- Macroeconomic factors: Macroeconomic factors can have a significant impact on the effectiveness of the Carry Trade. It is important to evaluate the political and economic stability of the economies involved in the strategy.
- Liquidity: Liquidity is important in any investment, and carry trade is no exception. It is important to ensure that the currencies being traded have sufficient liquidity to allow a quick entry and exit from the strategy
What role does the interest rate play in carry trade strategies?
The interest rate plays an essential role in the carry trade strategy, considering that the difference between interest rates generates profits. Returning to the main idea, once again, the carry trade is defined as a strategy in which an investor borrows funds in a currency with a low interest rate and then invests them in another currency with a higher interest rate, with the intention of obtaining profits from the difference between these interest rates.
What happens if there is a significant fluctuation in the exchange rate?
The carry trade carries certain risks, such as fluctuation of interest rates, changes in the exchange rate, and market volatility. Investors should conduct careful analysis before making carry trade operations and ensure they have a solid risk management strategy at all times to protect their assets.
Advantages and disadvantages of carry trade
|✅ Benefit from the difference in interest rates.
|❌ Leverage can lead to significant losses.
|✅ Use of leverage to multiply profits (but also increases risk).
|❌ Currencies are volatile; traders must stay informed about central bank actions and interest rate changes.
|✅ Potential for passive income.
|❌ Risk of adverse exchange rate fluctuations.
|✅ Suitable for long-term strategies.
|❌ Dependent on global political and economic stability.
|✅ Less need for constant technical analysis.
|❌ Exposure to unexpected market events that can alter trends.
What are the risks of carry trade strategy?
The carry trade strategy presents inherent risks such as fluctuations in exchange rates and market volatility. It is essential to have a solid risk management strategy to safeguard capital.
The fluctuation of interest rates can directly impact the profitability of the carry trade. Changes in the monetary policies of central banks, as well as market expectations, can generate variations in the interest rates of the currencies involved.
Additionally, the movements in the exchange rates between the currencies used in the carry trade can generate significant gains or losses. The volatility in financial markets, economic conditions and geopolitical factors can influence exchange rates, which adds an additional level of risk.
The general market volatility can also affect the carry trade. Abrupt changes in market conditions, such as unexpected economic events or financial crises, can generate sharp movements in asset prices and increase uncertainty.
How can risks be minimised in carry trade?
- Limit leverage: Leverage can significantly increase potential profits, but it also increases risk. Limiting the leverage used in the strategy will help minimise risk and avoid large losses in case of a market fluctuation against the position.
- Diversify the portfolio: One way to minimise risk is to diversify the Carry Trade portfolio and never invest more than 1%-2% of your capital in one position. Instead of investing in a single currency, it is advisable to invest in several different currencies, which will help reduce exposure to the risk of a single currency.
To minimise risks, it's important to carry out a thorough analysis of economic and financial conditions, as well as closely monitor monetary policies and relevant events.
Learn more about trading and investment strategies
The carry trade strategy is used in the forex market and aims to make profits by borrowing one currency to buy another. As an additional fact, if you are interested in using this investment strategy, the best way to do it is by finding a high-quality broker that offers competitive commissions for buying and selling currencies, such as the best forex brokers.
How do changes in central bank policies affect carry trades?
Central bank policies directly influence interest rates. If a central bank changes rates or indicates future changes, it can impact the attractiveness and risk profile of carry trades.
How do investors manage risk in carry trades?
Risk management can involve setting stop-loss orders, using currency options for hedging, diversifying investments, and closely monitoring market and political events that could affect currency values.
Can individual investors participate in carry trades?
Yes, individual investors can engage in carry trades, but it requires a good understanding of forex markets, interest rate trends, and currency risks. It's also important to have a sound risk management strategy.