Carry trade is one of the most commonly used strategies in fx trading wherein a person borrows money in a currency of low interest rate and uses the same to invest in a currency of higher interest rate. The basic purpose of a carry trade is to make money by leveraging the spread in interest rates, which is termed as “interest rate differential.” It may generate handsome returns, but it can be very risk-prone, too. Now, let us try to break down what actually forms the basis of a carry trade and why investors adopt it.
A carry trade fundamentally relies on borrowing and lending. Traders find currency pairs having one currency with a low interest rate and the other currency with a higher interest rate. For example, if the Japanese yen carries a low interest rate, then the Australian dollar will have a high interest rate. The trader borrows the Japanese yen and invests it in order to purchase the Australian dollars. The trader earns interest on the Australian dollars and pays a lower interest rate on the borrowed yen. The profit will be the difference between the two interest rates.
The only way this strategy will work is if the trader knows how interest rate differentials impact their trades. In a carry trade, a trader is essentially collecting interest payments on the currency that they are buying and paying interest on the currency that they borrowed. If the difference in interest rates is large enough, the trader can make a good profit from the interest alone, even if the price of the currency pair does not move significantly.
However, a few critical aspects should be looked into before the carry trade can be implemented. One is interest rate differential stability. Interest rates around the globe are adjusted freely by the world’s central banks, as their conditions are perceived at any moment in time. Thus, raising or lowering the interest rate by one of the banks could quickly flip the script for the carry trade. For example, when the Reserve Bank of Australia surprises the market with a cut in interest rates, then the trader will no longer be able to earn that interest rate differential again, which is going to adversely affect the trade.
Carry trades are also subject to the overall market environment in the sense of investor appetite for risk. The better the markets are and the more risk-willing investors are, the better the carry trades do. This is because traders borrow low-yielding currencies to invest in higher-yielding ones. During times of stress in the market, such as when there is a crisis in an economy or uncertainty due to geopolitics, investors may be unwilling to invest in riskier assets and thus close their carry trades. Therefore, the prices move fast in either direction. This can potentially be against traders who hold carry trades.
A carry trade in fx trading is borrowing low-interest currency and buying a higher-interest currency so that one will benefit from the difference in the interest rates. It is one of the very profitable strategies although it has to be approached in the context of interest rate differentials, currency fluctuations, and market conditions. For FX traders who are interested in carrying out carry trades, it is essential to understand the risks involved and to use proper risk management techniques to protect profits and minimize potential losses.