What is a Carry Trade?: Definition, How It Works, Example, and Risks

A carry trade is a trading strategy that involves borrowing at a low interest rate and investing in an asset that provides a higher rate of return.

The economy is not always balanced; you will see different interest rates and returns on different assets. Such a situation where you can capitalize on the interest rate differential between two currencies or assets is known as carry trade. 

For example, you borrow money in a currency with low interest rates and then make an investment that offers a higher interest rate than the interest rate at which you borrowed the money. Here, the goal is to profit from the difference between the borrowing cost and the investment return.

The carry trade strategy is popular in the forex market because different currencies have different interest rates. However, it can also be used with other asset classes, like bonds and commodities.

How Does Carry Trade Work?

Here is the step-by-step process on how to carry trade works with an example of currency carry trade:

1. Borrowing Low: The first and most important thing is having a good knowledge of the market and interest rates across currencies so you can borrow money in a currency with a low interest rate, like the Japanese Yen (JPY). The benchmark interest rate in Japan is usually around 0.10 %, which is pretty low, and a good carry trade strategy can be made around it.
   
2. Investing High: After you borrow money at lower interest rates, you use the borrowed funds to invest in a currency with a higher interest rate, such as the Australian dollar (AUD). Australia typically has a higher interest rate environment compared to Japan.
   
3. Profiting from the Spread: Ideally, the interest earned on your AUD investment will be greater than the interest you pay on the borrowed JPY. This difference between the two rates is your profit from the carry trade.

What are the Types of Carry Trades?

There are three main types of carry trades:

1. Currency Carry Trades: The previous section gave an example of a currency carry trade. This is the most famous and traditional type of carry trade, in which you borrow in a low-interest-rate currency and invest in a high-interest-rate currency. 
2. Fixed Income Carry Trades: In fixed-income carry trades, you borrow funds at short-term interest rates and invest those funds in fixed-income securities, which offer higher rates of return. For example, borrowing money at the short-term rate and using it to purchase corporate bonds that take a long time – years to mature and offer a higher coupon payment.
   
3. Commodity Carry Trades: Commodity Carry Trades involve borrowing money to invest in commodities that are expected to increase in value. The idea is that as the commodity price increases, it will generate returns. However, you’ll have to pay interest on the borrowed funds as a cost. For example, you could borrow money to buy and hold crude oil futures contracts, expecting oil prices to rise.

Is carry trade profitably?

Any form of trading is profitable or not, depending upon the individual. The profitability of carry trading depends on factors like the strategy used, the trader’s experience and knowledge, etc. Carry trading can be a profitable endeavor, but it requires experience and skill. While any carry trade strategy can be lucrative, it’s crucial to understand the potential benefits and risks involved before deciding.

What are the Benefits and Risks of Carry Trades?

Benefits

1. Interest Rate Differential: The main benefit of carry trading is that it uses the simple interest rate differential and profits from the difference between the borrowing and investment rates. In a successful carry trade, the higher return on your investment outweighs the borrowing cost, generating a net profit.
   
2. Leveraging: Carry trades can be leveraged; you can borrow a larger sum than you initially invested. This can increase your potential returns without putting much money into it. However, it’s important to remember that leverage also magnifies potential losses.

Risks

1. Currency Risk: Fluctuations in exchange rates can significantly increase the risk in forex currency trades, and major market swings can impact your investments. If the currency you borrowed (low interest rate) appreciates against the currency you invested in (high interest rate), your profits could be eroded or even lost.
   
2. Interest Rate Risk: Changes in interest rates can affect your carry trade strategy. If interest rates rise in the currency you borrowed, your borrowing costs will increase, squeezing your profits. Conversely, if interest rates fall in the currency you invested in, your returns could decrease.
   
3. Volatility Risk: Carry trades can be vulnerable to market volatility. Sudden price swings in the underlying currencies or assets can lead to substantial losses if you’re not properly hedged or have a high leverage ratio.

What are Key Considerations in Carry Trades?

• Interest Rate Differentials: As I have said earlier, knowledge and experience in the interest rate market are very important. You have to assess the difference between the borrowing and investment rates thoroughly. A higher interest rate difference between the borrowed and invented money is good for carry traders.
  
• Market Volatility: The major threat to carry trading is high market volatility, which can greatly increase its associated risks. Based on news or events, currencies and other assets can show major price swings, potentially wiping out your profits or even leading to losses.
  
• Hedging Strategies: Options and futures contracts are commonly used to hedge in carry trades. Implementing appropriate hedging strategies can help protect your profits and limit potential losses.

How to Execute a Carry Trade?

Here are step-by-step procedures on how you can execute carry trade:

Identify Suitable Currencies/Assets

Analyze the correlation between currencies and assets; if the asset or currency you choose moves in the same direction, that can reduce the interest rate differentials and increase your loss. Economic factors like repo rate or any other major directly affect carry trading, so consider all these factors when choosing an asset to trade.

Borrow Funds

Many brokers offer margin accounts that allow you to borrow funds to execute carry trades. Read all the documents, requirements, and guidelines provided by the broker to see if there are any hidden charges or something. After you choose where to borrow funds, check all the costs associated with the borrowing and all the instructions for the interest rates.

Invest

Once you have borrowed funds, your next step is to invest them in a higher-yielding asset or currency. You can use various assets for investment, like deposits, bonds, or other financial instruments, which can give more returns.

Monitor and Adjust

Once you have invested, your job is to monitor it because various events can influence the interest rate across the market. If any event impacts the investment, you can adjust it accordingly. Also, explore hedging strategies to protect against adverse currency movements or interest rate changes.

Educational Resources and Tools

Books like “Carry Trade Strategies” by Jessica James and Ian Marsh offer detailed explanations and case studies, making them valuable for beginners and experienced traders. Articles in financial journals and online publications such as Investopedia and Seeking Alpha provide up-to-date insights and practical advice.

Online courses are also an excellent way to learn the intricacies of executing and managing carry trades. Financial tools can also be very helpful. Carry trade calculators help you determine potential profits by considering interest rate differentials, leverage, and other variables. 

Braden Chase

Braden Chase is an investor, trading specialist, and former research specialist for Forex.com who helps aspiring investors develop the confidence and habits they need to make an income from the market. Braden has served as a registered commodity futures representative for domestic and internationally-regulated brokerages and has also spoken & moderated numerous forex and finance industry panels across the globe.

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