Carry trading is a popular strategy used in the foreign exchange market (forex). It involves borrowing money in a currency with low interest rates and investing it in a currency with higher interest rates. The goal is to earn a profit from the difference in interest rates, known as the carry, while also profiting from any currency appreciation.
Carry trading is based on the concept of interest rate parity, which states that the difference in interest rates between two currencies should be equal to the expected change in their exchange rates. For example, if the interest rate in the United States is 2% and the interest rate in Japan is 0.5%, then the expected change in the exchange rate between the US dollar and the Japanese yen should be around 1.5%.
To execute a carry trade, traders usually borrow money in a currency with low interest rates and then convert it into a currency with higher interest rates. They then invest the borrowed money in the higher-yielding currency and wait for the interest payments to accumulate. If the exchange rate also appreciates during this time, the trader can earn a significant profit.
For instance, let’s say a trader borrows $100,000 in Japanese yen at an interest rate of 0.5% and converts it to US dollars, which have an interest rate of 2%. The trader then invests the $100,000 in US Treasury bonds, which yield 2%, and holds the position for one year. During this time, the trader earns $2,000 in interest payments from the US Treasury bonds and pays $500 in interest payments to the Japanese lender, resulting in a net profit of $1,500.
However, carry trading is not without risk. If the exchange rate between the borrowed currency and the invested currency moves against the trader, the resulting loss can easily wipe out any interest payments earned. For example, if the exchange rate between the US dollar and the Japanese yen falls by 2%, the trader would lose $2,000 on the exchange rate alone, wiping out the $1,500 earned in interest payments.
Another major risk of carry trading is known as the “carry trade unwind.” This occurs when investors suddenly sell off their investments in higher-yielding currencies, causing a rapid depreciation in the currency’s value. This can result in significant losses for carry traders, as they may not have enough time to close their positions before the currency’s value falls.
To mitigate these risks, traders often use stop-loss orders and limit orders to manage their positions. They also carefully monitor economic and political developments in the countries they are trading in, as these can have a significant impact on interest rates and exchange rates.
In summary, carry trading is a popular strategy in forex that involves borrowing money in a currency with low interest rates and investing it in a currency with higher interest rates. The goal is to profit from the difference in interest rates while also benefiting from any currency appreciation. However, carry trading is not without risk, and traders must carefully manage their positions to avoid significant losses.