Currency Carry Trades

What Are Currency Carry Trades?

A currency carry trade is a method some investors use in an effort to meet their financial objectives. The basic idea behind this strategy is selling a currency with a low interest rate and then using the resulting funds to buy a currency with a higher interest rate. By harnessing this approach, an investor can try to capture the difference in interest rates, or interest-rate differential.

Carry Trades

Before delving into any foreign exchange transactions, investors might benefit from learning the basics of carry trades. A carry is the return someone receives for holding an asset.^[1] If retaining the asset produces a negative return, the carry is the resulting cost.

Currency Carry Trades

Now that you have a better idea of how carry trades work, let's explore how this concept can be applied to currencies. For starters, you could borrow a currency, such as the Japanese yen, for a very low interest rate. After doing so, you could convert the yen to the U.S. dollar and use the greenback to buy U.S. Treasuries.

As long as these U.S. Treasuries provide higher yields than their Japanese counterparts, the aforementioned transaction produces a positive carry, meaning a positive return. Lower yields would cause a loss.

For example, if you borrow ¥10,000 from a Japanese bank at 0.25%, convert it to the U.S. dollar and then use the resulting money to buy bonds that pay 2%, you stand to turn a profit of 1.75% as long as the exchange rate remains constant. Should the exchange rates change, you could sustain a loss which could exceed your deposited funds.

In the event you decide to use leverage, these returns, or losses, can increase substantially. By harnessing 10:1 leverage in the aforementioned situation, you can generate returns of 17.5%. However, using this much leverage when setting up currency carry trades can produce equally sharp losses which may exceed your deposited funds.

Keep in mind that currency carry trades do not always generate a return, and that unexpected changes in interest rates can generate losses. If you use the aforementioned strategy of borrowing the yen, converting it to the greenback and buying U.S. Treasuries, you could experience a loss should the yields on these bonds fall below the interest rate paid to borrow Japan's currency.

If you borrowed ¥10,000 at 2% and then bought U.S. Treasuries yielding 0.25% with the resulting dollars, you would incur a loss of 1.75% as long as the exchange rate stayed constant. This loss would be amplified if you had harnessed leverage to amplify returns. For example, 10:1 leverage would make the aforementioned loss rise to 17.5%.

While this consequence might seem modest, carry currency trades can produce far greater losses. For example, a person could borrow $10,000 at 1%, convert that money to the pound and then use the funds to purchase 10-year U.K. government bonds that pay a 1.2% yield. As long as the exchange rate remains constant, the investor would make a 0.2% profit.

However, if the yield on the U.K. government bond suddenly plunged to 0.5%, this would result in the person suffering a 0.5% loss. Should the person use 10:1 leverage, the loss would increase to 5%.

Interest Rate Determinants

Currency carry traders may benefit from researching the factors that affect interest rates. For those looking to learn more about interest rates, here are some variables that are widely credited for influencing their fluctuations:

Supply And Demand: At the most fundamental level, interest rates are a function of the supply of and demand for capital. If investors and financial institutions have a high willingness to lend money to would-be borrowers, this will result in a high supply of capital. However, if these lenders are reluctant, the situation will be the exact opposite.

As for demand, aspiring homeowners, budding entrepreneurs and those seeking consumer credit (such as automobile loans) can help produce high demand for capital. However, if they are hesitant to take on debt, this desire for credit could be far lower.

Inflation: Inflation can play an important role in interest rates by impacting how much financial institutions get paid back relative to how much they lend out. If prices rise very quickly, this development could easily reduce the purchasing power of the amount that lenders get paid back by borrowers.

A good example of high inflation is the 1970s^[2], when the Consumer Price Index surpassed 10% and the Federal Reserve responded by hiking the benchmark rates.^[3]

Alternatively, if the price level rises very slowly, lenders face less risk that the money repaid by borrowers will have weakened buying power. As a result, they may have greater incentive to loan out money at lower rates than they would in the event of higher inflation.

Exchange Rate Fluctuations

Investors may also trade by selling currencies in nations where they believe the central bank will cut benchmark rates or buy currencies in countries where they think the central bank will hike these rates.

As central bank policy decisions often hinge around business conditions, some traders are sure to stay abreast of the latest macroeconomic events.

Summary

The currency carry trade technique is widely used, as the broader foreign exchange markets frequently providers with opportunities to benefit from interest-rate differentials. However, those thinking about using such approaches should keep in mind that risk is inherent to investment. Interest-rate differentials can also generate losses. If you are considering currency carry trades, be sure to conduct substantial due diligence and/or consult an independent financial adviser.

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