Carry Trade: Definition, How It Works, Example, and Risks

Concerns about the carry trade had been rising for weeks, bdswiss forex broker review in part because of the enormous amount of money involved in it — an estimated $4 trillion. Those concerns soared on July 31, when the Bank of Japan raised interest rates from 0.1% to 0.25%. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer.

It appears that many investors are now unwinding their carry trade positions as the yen appreciates while the interest-rate spread narrows. Federal Reserve begin easing in September, this would further narrow the interest-rate differential. An effective carry trade strategy does not simply involve going long a currency with the highest yield and shorting a currency with the lowest yield. While the current level of the interest rate is important, the future direction of interest rates is even more important. For example, the U.S. dollar could appreciate against the Australian dollar if the U.S. central bank raises interest rates at a time when the Australian central bank is finished tightening its rates.

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They receive high-interest rates on the money invested but pay low-interest rates on the money borrowed. The currency broker pays the difference into the trader’s account each day. In a carry trade, a trader profits from the difference in two countries’ interest rates, as long as the exchange rate between the currencies does not change significantly. Carry trade is used by many professional traders because leverage allows them to magnify the potential gains.

Which investment strategies use carry trading?

• In any country, interest rates are a function of the economics within that country.
• It is best to combine carry trading with supportive fundamentals and market sentiment.
• “The carry trade unwind, at least within the speculative investing community, is somewhere between 50%-60% complete,” Arindam Sandilya, co-head of global FX strategy at JPMorgan Chase, told Bloomberg TV on Tuesday.
• Alternative investment strategies, including global macro funds and other hedge funds, use carry trading and may combine it with positions that can also take advantage of the momentum in exchange rate movements.

Similarly, these trades work well during times of low volatility since traders are willing to take on more risk. As long as the currency’s value doesn’t fall—even if it doesn’t move much, or at all—traders will still be able to get paid by collecting the interest rate differential. A once-popular carry trade involved selling the Japanese Yen against the Australian or New Zealand dollar. The Bank of Japan maintained negative interest rates between 2016 and 2024, making the yen a great currency to borrow and fund high-yielding currencies like AUD and NZD.

Understanding Carry Trades

Carry trades attempt to exploit differences in interest rates from central banks relating to two currencies. In carry trades, investors borrow money in a low-interest-rate currency (the funding currency) and use it to invest in high-yielding assets denominated in another currency (the target currency). Though we’ll complicate this depiction in a moment, the goal is to profit from the interest rate differential and potential appreciation of the target currency. The yen carry trade, a popular strategy among investors, involves borrowing funds in Japanese yen—historically known for its low interest rates—and investing in higher-yielding assets such as U.S. The 2024 market correction triggered by the unwinding of yen-related carry trades was not unprecedented. In practice, most carry traders don’t physically exchange currencies.

Simultaneously, volatility jumped to its highest level all year and, on Monday, continued to surge to its highest since March 2020’s Covid-19 selloff. The data prompted some to wonder whether policymakers had put themselves behind the curve by foregoing a July rate cut, keeping the benchmark rate at a range of 5.25% to 5.50%. It also raised the prospect that the Fed could make a big 50 basis-point cut in September or even hold an emergency meeting to lower rates before then. Joe finds a currency pair whose interest rate differential is +5% a year and he purchases $100,000 worth of that pair. But when a popular carry review encyclopedia of chart patterns trade abruptly stops working, the effects can be widespread.

Do Central Banks Play Any Role In the Dynamics Of Carry Trades?

If enough investors do this, it boosts demand for high-interest rate bonds. The investors can sell these bonds at a profit on the secondary market. This amount can only be earned by traders who are long on AUD/JPY. Interest is paid every day to those who are fading the carry or shorting AUD/JPY. We introduce people to the world of trading currencies, both fiat and crypto, through our non-drowsy educational content and tools. We’re also a community of traders that support each other on our daily trading journey.

As the current market backdrop exemplifies, carry trading can be a high-risk strategy; therefore, it requires expert risk management to minimize the potential for large losses. Alternative investment strategies, including global macro funds and other hedge funds, use carry trading and may combine it with positions that can also take advantage of the momentum in exchange rate movements. Beyond alternative investments, a range of other investment strategies may use carry trades too.

Thomas’ experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning. This is the cost of “carrying” (also known as “rolling over“) a position to the next day. Brokers close and reopen your position, and then they debit/credit you the overnight interest rate differential between the two currencies. You pay interest on the currency position you SELL and collect interest on the currency position you BUY. John Hancock Investment Management LLC is the investment advisor for the closed-end funds. So your profit is the money you collect from the interest rate differential.

You just don’t see it happen if you hold a position to the next day. If you borrow in yen and then trade in dollars (or euros, which have similarly fallen versus the yen), and then the yen gains value, you have to earn more dollars or euros to pay back your yen-denominated loan. The yen reacted almost immediately to the rate hike, rising to about 150 to the U.S. dollar from about 162 to the dollar earlier in July. (We say that the yen “rose” because it gained value relative to the dollar.) The yen has risen even further since, trading at around 143 to the dollar on Monday morning. It aims to produce a cheaper yen and a stronger dollar to make its exports cheaper. It keeps long-term interest rates low even when the Federal Reserve raises short-term rates.

A major reason carry trades are best done by those with deep pockets is that timing protective measures like buying option to hedge currency changes can be challenging and costly if maintained too long. Put another way, you need to have made chapter 4 models and services roughly 13% on that borrowed money in one month just to break even on the loan. That’s a much bigger deal than the Bank of Japan’s 0.15% interest rate hike.