Carry Trade in Forex
A carry trade is a financial strategy where an investor borrows funds in a low-interest currency (funding currency) and invests them in a higher-interest currency (target currency). The goal is to profit from the difference in interest rates, known as the «carry.»
How Carry Trades Work:
1. Borrow at a low interest rate: The investor borrows funds in a currency with a low interest rate, such as the Japanese yen (JPY).
2. Invest at a higher interest rate: The borrowed funds are invested in a currency with a higher interest rate, such as the Australian dollar (AUD).
3. Rollover profits: As the interest payments from the higher-interest currency exceed those from the lower-interest currency, the investor uses the excess to repay the borrowing costs.
4. Profit from interest rate differential: The profit is earned from the difference between the interest rates paid on the borrowed funds and earned on the invested funds.
Benefits of Carry Trades:
Potential for high returns: If the interest rate differential is significant, carry trades can generate substantial returns.
Diversification: Carry trades involve borrowing and investing in different currencies, which can provide diversification benefits to a portfolio.
Risks of Carry Trades:
Currency risk: Carry trades are exposed to currency fluctuations. If the target currency depreciates against the funding currency, the investor may lose money.
Interest rate risk: If the interest rate on the borrowed funds increases, the cost of the carry trade may exceed the profits earned from the higher interest rate on the invested funds.
Refinancing risk: Carry trades rely on constant access to low-cost funding. If the funding currency becomes more expensive, the investor may struggle to refinance the loan.
Example of a Carry Trade:
Borrow 100,000 Japanese yen (JPY) at 0.1% interest rate.
Invest the borrowed JPY in 100,000 Australian dollars (AUD) at 3% interest rate.
Annual profit from interest rate differential: 2.9% (3% — 0.1%)
After one year, the investor has earned 2,900 AUD (2.9% of 100,000 AUD).