what is a currency carry trade 
a currency carry trade is a strategy whereby a high yielding currency funds the trade with a low yielding currency a trader using this strategy attempts to capture the difference between the rates which can often be substantial depending on the amount of leverage used the carry trade is one of the most popular trading strategies in the forex market the most popular carry trades have involved buying currency pairs like the australian dollar japanese yen and new zealand dollar japanese yen because the interest rate spreads of these currency pairs have been quite high the first step in putting together a carry trade is to find out which currency offers a high yield and which one offers a low yield the basics of a currency carry tradethe currency carry trade is one of the most popular trading strategies in the currency market consider it akin to the motto buy low sell high the best way to first implement a carry trade is to determine which currency offers a high yield and which offers a lower one the most popular carry trades involve buying currency pairs like the aud jpy and the nzd jpy since these have interest rate spreads that are very high as for the mechanics a trader stands to make a profit of the difference in the interest rates of the two countries as long as the exchange rate between the currencies does not change many professional traders use this trade because the gains can become very large when leverage is taken into consideration if the trader in our example uses a common leverage factor of 10 1 he can stand to make a profit of 10 times the interest rate difference the funding currency is the currency that is exchanged in a currency carry trade transaction a funding currency typically has a low interest rate investors borrow the funding currency and go short while taking long positions in the asset currency which has a higher interest rate the central banks of funding currency countries such as the bank of japan boj and the u s federal reserve often engaged in aggressive monetary stimulus which results in low interest rates these banks will use monetary policy to lower interest rates to kick start growth during a time of recession as the rates drop speculators borrow the money and hope to unwind their short positions before the rates increase the best time to get into a carry trade is when central banks are raising or thinking about interest rates many people are jumping onto the carry trade bandwagon and pushing up the value of the currency pair similarly these trades work well during times of low volatility since traders are willing to take on more risk as long as the currency s value doesn t fall even if it doesn t move much or at all traders will still be able to get paid but a period of interest rate reduction won t offer big rewards in carry trades for traders that shift in monetary policy also means a shift in currency values when rates are dropping demand for the currency also tends to dwindle and selling off the currency becomes difficult basically in order for the carry trade to result in a profit there needs to be no movement or some degree of appreciation currency carry trade exampleas an example of a currency carry trade assume that a trader notices that rates in japan are 0 5 percent while they are 4 percent in the united states this means the trader expects to profit 3 5 percent which is the difference between the two rates the first step is to borrow yen and convert them into dollars the second step is to invest those dollars into a security paying the u s rate assume the current exchange rate is 115 yen per dollar and the trader borrows 50 million yen once converted the amount that he would have is u s dollars 50 million yen 115 434 782 61after a year invested at the 4 percent u s rate the trader has ending balance 434 782 61 x 1 04 452 173 91now the trader owes the 50 million yen principal plus 0 5 percent interest for a total of amount owed 50 million yen x 1 005 50 25 million yenif the exchange rate stays the same over the course of the year and ends at 115 the amount owed in u s dollars is amount owed 50 25 million yen 115 436 956 52the trader profits on the difference between the ending u s dollar balance and the amount owed which is profit 452 173 91 436 956 52 15 217 39notice that this profit is exactly the expected amount 15 217 39 434 782 62 3 5 if the exchange rate moves against the yen the trader would profit more if the yen gets stronger the trader will earn less than 3 5 percent or may even experience a loss risks and limitations of carry tradesthe big risk in a carry trade is the uncertainty of exchange rates using the example above if the u s dollar were to fall in value relative to the japanese yen the trader runs the risk of losing money also these transactions are generally done with a lot of leverage so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately an effective carry trade strategy does not simply involve going long a currency with the highest yield and shorting a currency with the lowest yield while the current level of the interest rate is important what is even more important is the future direction of interest rates for example the u s dollar could appreciate against the australian dollar if the u s central bank raises interest rates at a time when the australian central bank is finished tightening its rates also carry trades only work when the markets are complacent or optimistic uncertainty concern and fear can cause investors to unwind their carry trades the 45 sell off in currency pairs such as the aud jpy and nzd jpy in 2008 was triggered by the subprime turned global financial crisis since carry trades are often leveraged investments the actual losses were probably much greater correction march 22 2024 this article has been corrected to state that in a currency carry trade transaction investors borrow the funding currency and go short while taking long positions in the asset currency 