What is Carry Trade? Explanation and Examples

What is Carry Trade? Explanation and Examples

Borrowing money at lower interest rates and investing it in higher-yielding assets is the simplest description of a classical carry trade approach. The concept itself was popularized by Japanese housewives who often were in charge of family funds and together with personal computers and internet rise started to trade Japanese yen and US dollar. Let’s dive deeper into carry trade and explain popular strategies everyone can use. 

What is a Carry Trade?

If the Japanese yen can be borrowed for 1% and the USD or other currency has a higher interest rate of 5%, it could be feasible to borrow the Japanese yen and buy the USD. This is a simplification of a carry trade but the basic concept is clear, you want to borrow cheaply and invest in assets with higher interest rates. A more formal definition would be like this: Carry trade is a financial strategy where an investor tries to borrow money in a currency with a low interest rate and invest it in a currency or asset offering a higher interest rate. An investor employing a carry trade aims to make money in interest rate differential. Carry trade is only achievable when the high-yielding currency investment exceeds the cost of borrowing in the low-yielding currency. So, we are leveraging the difference in interest rates between two financial instruments or currencies. 

Origins of carry trade

The strategy was born in currency markets where it is possible to exchange one currency for another and as the electronics allowed wide access to foreign exchange markets, carry trade gained wild popularity. Japanese housewives were among the first ones to start making a lot of money using the carry trade strategy. Japanese banks usually had the lowest interest rates among currencies. Traders widely used these low-interest rates to invest yen into USD, which had higher yielding rates. This policy of the Japanese central bank made the Japanese yen (JPY) a popular choice for the low-interest-rate currency, in carry trade transactions. The strategy was so widely used by the Japanese community that the women using the carry trade were called Mrs. Watanabe. This became a symbol of fearless women and was a very popular term among Japanese communities. 

The Mechanics of Carry Trade & Step-by-Step Guide

The simplest way to carry a carry trade is to borrow money in low-interest-rate currency, convert it into a high-interest-rate asset, invest it, and aim to profit from the interest rate difference. Let’s pick an example and a step-by-step process to help our readers and investors understand how this method works.

Step Zero: Set up an account with a trusted Forex broker

Before you can use a carry trade strategy, you need to select a legit broker. Reliable brokers are also well-regulated, which you can check on their website. Ensure the broker has the currencies or assets you want to carry trade. 

Step One: Monitor interest rates

The first thing to do after the trading account is ready is to check for interest rates of JPY (Japanese Yen) and USD. You want to confirm that JPY has a lower interest rate than USD or vice versa. It could also be cryptocurrencies and fiat currencies. Check if staking rewards are much more than the cost of borrowing the money. For simplicity, we will use JPY and USD as an example. 

Step two: Borrow the currency with a lower interest rate

After you have spotted a significant difference between the interest rates of the two currencies, it's time to start employing a carry trade. Borrow JPY from your broker, which typically involves selecting a leverage ratio (e.g., 10:1) to borrow a larger amount than your initial deposit.

Step three: Convert borrowed currency into an asset with a higher yield

Convert the borrowed JPY into USD at the current exchange rate. We convert from lower-cost currency to higher-yield currency. 

Step four: Invest in High-Yielding Assets

It may seem tricky but is a fairly straightforward process. We got your back. You can now invest your USD into high-yielding assets like US treasury bonds a savings account with a higher interest rate, or a cryptocurrency that offers higher staking rates. You must be extremely cautious with cryptos as they are known for large price swings and scams. 

Step Hero: Close your trades and take profits

Monitor the interest rates and ensure your carry trade stays relevant. When you decide to close your trade repay the yen with interest and if the USD investment had a higher yield rate you will get a profit. 

Risk Factors in Carry Trade

As would already tell, there are risks involved with deploying the carry trade strategies. So, what are the exact risks involved in carrying trade strategies? Let’s consider all of them and find a solution for each one.

Exchange Rate Risk

This is the most obvious and dangerous risk of the carry trade approach. If the currency value fluctuates too quickly and the yen appreciates there is a serious chance of losing money. Suppose you borrowed the yen to get USD. But suddenly, the yen started to appreciate against the dollar. Now each of your USD can buy less yen, meaning if you exchanged your funds back to yen you would get less money than what you borrowed. This is a common risk associated with carry trade and usually the major one behind losses. 

Interest Rate Risk

This one has a lesser impact, because if the interest rate on USD starts to decline you still can easily convert back to yen and end up in break even. 

Liquidity Risk

Liquidity means how fast you can convert your currency to another one. In the case of exotic currencies with lower trading volumes, spreads, and commissions are usually high, eating up most of the profits. But a more serious issue is: that it is difficult to convert exotic currencies into another currency. And if the exchange rate is changing fast you do not want to wait a long time before you can convert your money back. In the case of yen and USD, this is very low risk as both currencies are major currencies with high liquidity all the time. 

Is Carry Trade relevant today?

Crypto markets gained huge capitalization by the low-interest rates in the United States. Investors would borrow money and invest in high-yield crypto-staking projects making lots of money in the process. Since cryptos are super risky and known for an abundance of scams and frauds, many people also lose lots of money. But this is by far the most relevant example of a modern carry trade. 

Carry Trade Strategy Tips

If you are planning to deploy a carry trade strategy, make sure you take into account these tips. 

  • Ensure that the economic situation is stable in both countries you are going to convert funds. Exchange rate risk can quickly render any carry trade strategy useless, so stable economic periods are best for this kind of approach. 
  • Constantly monitor your positions and ensure there are no major changes in interest rates. Always use stop loss if you are using Foreign exchange markets to limit losses. 
  • Try to avoid using exotic pairs with low trading volume and wide spreads, this way you will be able to quickly close your carry trade, limit losses, and take profits. 

Key Takeaways

  • Carry trade refers to borrowing in a low-interest-rate currency and investing in a high-interest-rate asset to make a profit from interest rate differentials.
  • The strategy gained widespread popularity with Japanese investors including housewives which was caused by Japan’s low interest rate environment.
  • Mechanics for implementing a carry trade: Borrow funds in the low-interest-rate currency, convert them into high-yield assets, invest, and profit from interest rate differential.
  • A step-by-step process for simple carry trade: select a reputable broker, monitor interest rates, borrow lower-rate currency, convert to a higher-rate asset, invest, and close trades to take profits. 
  • Three major risks in carry trade include exchange rate risk(currency value fluctuations), interest rate risk(rate changes), and liquidity risk (difficulty in converting currencies in time).
  • The most modern form of the carry trade is when investors borrow low-interest-rate USD and invest in into crypto projects to make money from staking which usually has higher yield rates. 
  • Carry trade strategy tips: Ensure economic stability in both countries, monitor positions, use stop-loss orders, and avoid exotic currency pairs with low liquidity.