Introduction to the Carry Trade

In this article we’ll cover a non-directional trading strategy that has been popular among banks and hedge funds, yet is lesser known among retail traders. The strategy most famously used the Japanese Yen in the mid 1990’s and again in 2004-2008.

The Yen is again being used as the funding currency for the carry trade, with the Bank of Japan (BoJ) maintaining its key short-term interest rate at -0.1%. Meanwhile, the Federal Reserve raised interest rates by 0.25 percentage points to a range between 4.50-4.75% at its policy meeting ending 1 February.

Basic Forex Concepts

Currencies are traded in pairs – the currency to the left of the pair is known as the base currency, and the currency on the right of the pair is called the quote or counter currency. The price of a currency pair reflects how much of the quote currency an investor would have to spend in order to buy one unit of the base currency.

When you trade a currency pair, you simultaneously buy one side of the pair and sell the other. This mechanism allows traders to potentially capitalize on different interest rates among currencies.

What is the Carry Trade?

The carry trade strategy is based on buying a high interest yielding currency and selling a low yielding currency. You are buying and earning interest on one currency and selling and paying interest on the other. Currencies traded in pairs and traders are simultaneously selling one currency while buying another. The price of a currency pair reflects the price of how much of the quote currency a trader would have to spend in order to buy one unit of the base currency.

The forex market allows the trader to earn the difference in the interest rates between the two currencies. The ‘carry’ of an asset is the positive return earned by holding it. Each country sets its own interest rate, based on the money supply and inflation. The funding currency has a low interest rate, while the target interest rate has a high interest rate.

Interest Rate Differentials

The differences between interest rates of countries is what creates this opportunity. Countries who are experiencing economic growth will offer higher rates of interest. However, with the higher interest rates comes risk – there is no guarantee that the country’s economy will be able to pay the interest on it’s currency.

For example if the Japanese Yen offers an interest rate of 0.25% and the New Zealand dollar offers an interest rate of 6.25%, someone selling the Yen and buying the New Zealand dollar can earn a profit of 6% as long as the exchange rate between the New Zealand dollar and yen remain unchanged. The Yen and the Swiss Franc have been the main funding currencies due to their low interest rates. Some speculators hedge the exchange rate exposure – aiming only to capture the interest rate differential.

Why do Central Banks Lower Interest Rates?

Central banks lower interest rates to fight against deflation and boost a stagnating economy. Concerns about the outlook for economic growth, low inflation and weakening business and consumer confidence. may influence central bankers to cut the benchmark interest rate.

Why do Central Banks Raise Interest Rates?

Conversely, central banks raise interest rates when inflation is predicted to rise above their inflation target. Higher interest rates tend to limit economic growth. Higher interest rates increase the cost of borrowing, reduce disposable income and restrict growth in consumer spending.

The Role of Leverage

The forex market offers an unusually high degree of leverage and this can be used to amplify the earnings from the carry trade. For example, a 3% interest rate differential will generate a return of 300% on an account that is leveraged at 100:1.

Exotic and Emerging Market Currencies

A carry trade involving an exotic currency such as the Turkish Lira can produce large returns with little or no leverage used. The Turkish Lira currently has an interest rate of 16.5%. Investing in exotic currencies is much higher risk but gives you the earnings of the interest rate differential as a cushion. The currencies with the highest interest rates in the world currently are: the Argentine Peso (with a benchmark interest rate of 63%, Argentina has had the world’s highest interest rates for over a year to tame spiraling inflation and depreciation), Egyptian pound (12.250 %),  the Mexican Peso (7.500 %), the Russian Ruble (6.500 %) and the South African Rand (6.500 %).

Carry Trade Risk

The risk in the carry trade is that the currency you are long and is yielding the higher level of interest depreciates in value against the funding currency. Being highly leveraged will naturally magnify the loss in this scenario.

A second risk stems from the fact that interest rates are subject to change. A change in the interest rate that narrows the interest rate differential will cut into your profits from the trade.

An interesting aside – some traders have tried to hedge their carry trades using Islamic accounts, which are swap free. They go long the high yielding pair/short the low interest pair in one account. They then hedge the risk of the price falling in the high yielding currency by taking the opposite position (short the high yielding currency/long the lower yielding currency) in the swap free account. I am not recommending this and most brokers have controls in place to prevent the abuse of swap free accounts.

History of the Carry Trade

The 1990-1991 recession in the United States led to a drop in interest rates. A carry trade using the dollar as the funding currency and the Asian and Latin American investments as the target. By the mid-1990’s a reversal happened and marked the beginning of the Yen carry trade. Bank of Japan first cut interest rates to zero percent (ZIRP). The original ‘yen carry trades’ came unstuck in the financial crisis of 1998.The Yen carry trade was popular during the 1990’s and also from 2004-2008. In the years leading up to the financial crisis of 2008, the Yen weakened – so investors both make money on the interest rate differential and the appreciation of USD/JPY. However, when the global financial crisis struck in 2008, investors piled into safe havens such as the Japanese Yen, causing it to appreciate and ending the profitability of the Yen carry trade.  During the 1990’s global investors also borrowed US dollars, and bought emerging market currencies such as the higher yielding pegged Thai baht on a leveraged basis. After investors started to withdraw from Thailand the central bank broke the peg and devalued the currency.

Unwinding of the Carry Trade

An ‘unwinding’ of the carry trade takes place when the interest rate differential narrows. As carry trade investors pulled out of their long euro and US dollar positions and short yen positions, the Yen appreciated in value. USD/JPY rate saw the biggest one-day swing since the collapse of the Bretton Woods exchange rate regime in the early 1970s.

Long Term Capital Management (LTCM)

The unwinding of the carry trade created some disastrous blow ups, such as the collapse of the U.S. hedge fund Long-Term Capital Management in 1998. LTCM was led by Nobel Prize-winning economists and leading Wall Street investors. Asian economic slump and Russia’s debt default triggered the flight to safe havens such as the Yen causing the carry trade to unwind.

Risk Appetite of the Market

Carry trades tend to do well in an environment of lower risk – when the market feels comfortable moving into higher risk, higher yielding assets. Conversely, as we saw in the example of the Carry Trade leading up to the 2008 financial crisis, Carry Trades are less feasible or impossible when investors flock to safe-haven, low-yielding assets. This drives up their prices and makes using them as a funding currency a losing proposition.

Current Examples of Carry Trades

Currently the Mexican Peso has an interest rate of 7.5% and the US dollar has an interest rate of 0.75%. This means that if you buy the Peso and sell the US dollar simultaneously, you would capture the interest rate differential of 6.75%. This can be achieved by selling short the USD/MXN currency pair.  The pair has been in a downtrend since late August. If price falls, you would earn from both the price movement of the pair and the interest rate differential of 6.75%. However, if price were to rise, you would lose money from the price movement which would wipe out any gains from the interest rate earnings.

Among the currencies of G10 countries, the JPY and CHF are commonly used as funding currencies, while the AUD, NZD, and CAD are among the higher yielding target currencies. Currently interest rates in Australia, New Zealand and Canada are at historic lows, but remain higher than interest rates in Japan. The Bank of Canada currently has an interest rate of 1.750 % while the Bank of Japan has its key short-term interest rate at 0.100 %. Another carry trade currency pair to consider is CAD/CHF. The Canadian dollar has an interest rate of 1.750 % and the Swiss Franc has an interest rate of -0.750 %.

Carry Trade and Volatility

The drop in currency market volatility has fueled appetite for carry trades where investors borrow in currencies with low or negative interest rates and invest in relatively higher yielding ones. Carry trades work well during times of low volatility as investors are willing to take on more risk. If the exchange rate remains static, the investor will still reap the interest rate differential.

Looking for Trend

So, in addition for looking to enter carry trades in a ‘risk on’ environment, when money flows out of safe-haven ‘funding’ currencies, investors can enhance their odds of success by being conscious of the broad market trend.  Being in an uptrend in the base currency – the currency you are buying and earning interest on – against the counter or ‘funding’ currency – the currency you sold and have to pay interest on. From a fundamental perspective, a good time to enter a carry trade is when the central bank of the currency you are buying is beginning a cycle of raising interest rates.

Swap Rates

The ‘rollover’ or swap rate for a currency pair is the net interest owed or earned overnight. Swap rates are typically calculated at 5PM eastern standard time and positions held after that time are considered as being held overnight. Check the rates being paid by your broker.

The Bottom Line

With stock markets making record highs and improving US/China trade relations, risk appetite in the market is on the rise – a potentially conducive atmosphere for carry trades.