Carry trades refer to any strategy wherein an investor borrows capital at a lower interest rate to invest in assets with high potential returns.
It is one of the most popular forex strategies because it can be entered by finding and selling a low-yielding currency and buying a currency with higher interest rates.
Here, let’s talk about what is carry trade and how investors profit from interest rate differentials in forex.
Understanding Carry Trades
The goal of carry trades is to profit from the interest rate differentials between a low-interest currency and high-yielding assets. The most popular carry trade example is the Japan carry trade.
In the 2000s, carry trading became very popular to the extent that it made up about 1/5 of the daily market turnover. Investors borrowed in Japanese yen because of its near-zero interest rates and put their money into assets with high yields abroad.
Although it is a profitable trading strategy, it is also risky due to sudden market shifts, which can erode profits quickly. Hence, this strategy is the best fit for investors with a high tolerance for risk and those who can afford to lose money.
Real-Life Example: The Japanese Yen Carry Trade
The yen carry trade is a popular strategy among investors that involves borrowing funds in Japanese yen and investing in high-yielding assets, such as the US Treasury, stocks, US dollars, Mexican pesos, or New Zealand dollars.
The Japanese yen carry trade started in 1999 when Japan’s interest rate became zero after its asset price bubble burst. Japanese people explored the international market to get better yields, turning Japan into the world’s biggest creditor nation.
In 2024, the unwinding of yen-related carry trades triggered a market correction. This unwinding caused significant currency fluctuations, with Japanese yen appreciating sharply against the usual carry trade target currencies such as the US dollar.
Unwinding refers to the mass exit of investors from a once-profitable strategy. During this process, investors liquidate assets bought with borrowed yen, use the proceeds to repurchase yen, and settle their yen debts, closing out their carry trade positions.
Various interconnected factors were at play in the unraveling of yen-based carry trades. One factor is the Bank of Japan raising interest rates from almost zero to 0.25%. Although such a change seems insignificant, it has huge impacts on carry trades.
This increase in interest rate was amplified by the expected interest rate cuts in the US over fears of a possible recession. As a result, the yen strengthened against other currencies, including the US dollar.
These factors completely wiped out the slim gains in pure yen-dollar carry trades. This scenario sparked a sell-off as traders looked to offload high-risk assets that burden them with high borrowing costs, minimal-to-zero profit margins, and losses in asset values.
This led to Japan’s Nikkei 225 index dropping by 12% on August 5, 2024, which is the second largest percentage decline. The S&P index also fell by 3% on the same day.
Risk Factors of Carry Trades
Here are some of the risk factors of carry trades:
Exchange Rate Risk
This is the most important factor that affects carry trades. If the funding currency increases against the target currency, then it can remove any gains from the interest rate difference.
Interest Rate Changes
Carry trades depend on the stability of the interest rate differentials. The profit margin can shrink or disappear if the central bank of the funding currency raises rates or the target currency’s central bank lowers rates.
This situation occurred in the carry trade unwinding of 2024.
Shifts in Market Sentiment
Many investors can pursue the same strategy, making carry trades crowded. This situation can lead to rapid, self-reinforcing movements when the market sentiment shifts in the other direction.
Devaluation Risk
Although this risk still happens today, it has been more prominent in the past decades. Emerging market currencies are often targets for carry trades due to higher interest rates.
However, these emerging market currencies can have sudden devaluations driven by a nation’s central bank. Although higher rates could suggest currency strength, rapid depreciation can be caused by hyperinflation or political unrest.
Volatility
Currency troubles can stem from increased volatility in local equity markets or capital outflows.
Changes in Economic Indicators
Economic indicators such as inflation rates, gross domestic product growth, and trade balances can influence currency values and interest rates, which affect carry trade profitability.
Economic Shocks
Unforeseen events can cause sudden fluctuations in currency, leaving traders with huge losses before they can exit their positions.
Frequently Asked Questions
What is the Most Popular Carry Trade?
The most popular carry trade is the yen carry trade.
Is Carry Trade Still Profitable?
Carry trade can be profitable. However, it also comes with considerable risks, especially with exchange rate fluctuations and sudden market shifts.
Are Carry Trades Risky?
Yes, it is risky due to factors such as exchange rate risk, interest rate changes, and shifts in market sentiment.
Conclusion: Is Carry Trading Right for You?
Carry trades can be an effective and lucrative way to earn profits from interest rate differentials, especially during periods of global monetary stability.
However, the 2024 yen carry trade unwinding proved that carry trading is a risky strategy. Factors such as sudden shifts in interest rates, market volatility, and changes in investor sentiment can turn potential profits into steep losses quickly.
If you are considering carry trades, make sure you understand how exchange rate movements impact your returns, keep track of central bank policy changes, and only invest funds that you can afford to lose.
Overall, carry trades can be profitable, but they are best suited for experienced traders who can handle market uncertainty and manage risk effectively. For cautious investors, diversifying across less volatile assets may be a safer path to steady returns.
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