The carry trade is a trading strategy that consists of borrowing (financing) at a low interest rate and using that financing to invest in assets that give a higher interest rate.
This strategy has traditionally been carried out in the forex market. The idea is that the investor is financed in a currency with a low interest rate to later invest that money in another currency with a higher interest rate. The objective is to buy financial assets that give a higher return than the cost of financing. Basically the carry trade consists of buying one currency and, at the same time, selling another currency.
Fundamentals of the carry trade
The carry trade exploits a violation of interest rate parity. Historical evidence has shown that the currency with the highest interest rate has depreciated less than predicted by the interest rate parity or even appreciated, which has allowed the carry trade strategy to obtain benefits. However, a small percentage of the time the currency with the highest interest rates has appreciated considerably, generating substantial losses to the carry trade strategy. This has happened especially when investing in emerging countries during periods of financial stress, when the invested currency has depreciated considerably.
In recent years, the main currency in which investors carry out the strategy has been the Japanese yen. This is because Japan has had very low interest rates for several decades. Therefore, they borrow in yen and then buy assets in dollars, euros, or another currency.
A common carry trade practice is to finance yourself in developed countries to invest in debt from emerging countries that offer higher returns. The risk of this operation is high since it is possible that the currency of the country where it is invested will depreciate greatly or even that there is a default on the debt.
The objective of the investor who performs this strategy is to bet that the currency in which it is invested will appreciate. So that when exchanging to the first currency the amount generated is higher. The positive of this strategy is that even if the exchange rate does not move, the investor will make a profit. This is because the profit is mainly based on the interest rate differential of both currencies.
With a much better example
Let's imagine that we want to carry out the carry trade on the yen / dollar currency, and that today it is trading at 108 yen per dollar. Since interest rates are lower in Japan, we will borrow in yen and invest in dollars. The process is the following:
- We borrow 2,000,000 yen to pay back within a year, at an interest rate of 0%. That is, within a year, we will return 2,000,000 yen.
- With 2,000,000 yen we buy dollars at the exchange rate of 108 yen per dollar. We get $ 18,519.
- With dollars we buy an American bond (today) with a maturity of one year that will give us 2.2% at maturity. So in a year, we'll get $ 18,926.
- Then we exchange the dollars into yen, assuming that the exchange rate has not changed, and we receive 2,044,053 yen.
- Finally, we repay the 2,000,000 yen of the loan. After which we have 44,053 yen of profit left. That is, a profit of 2.20%.
As has been seen, it would be a round operation from the point of view of profitability.
Does the carry trade have any risk?
As seen in the previous example, the strategy has been a benefit. But there is a risk that the operation will not end with profits. Let's imagine, for example, that the exchange rate depreciates after one year and let's see what would happen:
- Suppose that the exchange rate in one year goes from 108 yen per dollar to 95 yen per dollar.
- Once we have received the 18,926 dollars from the previous example, we exchange them for yen at the exchange rate of 95 yen per dollar.
- We will then receive 1,797,970 yen.
- We must repay 2,000,000 yen for the loan granted at the beginning of the year.
- Therefore, we would have a loss of 202,030 yen. What is the same, a loss of 10.10% in the operation.
Therefore, if the exchange rate does not move in our favor, the losses could be very high.
On the other hand, there would be an alternative risk in relation to the asset chosen to invest. The investor may be looking to invest in stocks, mutual funds, or the real estate market. As we know, there is no guaranteed positive return on these assets. In addition, in the case of investing in bonds, there is a risk of default by the issuer of the bond. So here we would not have the guaranteed profit either and the carry trade could generate losses.