Carry Trade: What it is and how it works

The carry trade is a speculative financial strategy used mostly internationally, based on the difference in interest rates between two countries. In simple terms, carry trade involves borrowing money in a currency that has a low interest rate and converting it into a currency of a country that offers higher interest rates. The goal is to generate a profit from the difference between the return on the investment and the cost of borrowing. This strategy is popular among investors who seek higher returns without necessarily having to take high risks.

A related concept is basis trading, which focuses on arbitraging price inefficiencies between similar financial instruments, such as futures and underlying assets. Both strategies require careful assessment of market conditions, such as exchange rate stability and the persistence of differences in interest rates. Investors often choose safe financial instruments, such as government bonds, because they provide a stable return and reduce the risk of loss of invested capital.

How does the carry trade work?

The carry trade works by exploiting a structural difference in the cost of money between two economies, with the goal of generating a stable and lasting gain. Investors borrow in a currency with a low interest rate, such as the Japanese yen in the 2000s, and invest the converted funds in another currency with a higher yield, such as the U.S. dollar. This process requires a relatively stable exchange rate between the two currencies, as large fluctuations in the exchange rate could undermine expected returns. A practical example was just Japan between 1996 and 2007, when the yen-dollar exchange rate was stable and the Japanese interest rate was at 0.25 percent. International investors could thus borrow money in yen at a minimal cost, convert it into U.S. dollars, and invest in U.S. government bonds, which offered significantly higher yields. The difference between the low cost of borrowing in Japan and the higher yield in the U.S. guaranteed a profit, as long as the exchange rate remained stable over time.

The risks and ideal conditions for the carry trade

Carry trade is not risk-free, although it is considered a relatively safe strategy if executed correctly. The success of this strategy depends on two main conditions: stable exchange rates and a significant and constant difference between the interest rates of the countries involved. An unstable exchange rate between the currencies used can cancel out expected gains or even turn a carry trade into a loss. In addition, global economic conditions can affect interest rates and, consequently, the potential carry trade profit. For example, a sudden rise in interest rates in the country of borrowing could make the trade no longer worthwhile. Therefore, carry trade investors must carefully monitor both interest rates and the exchange rate between currencies to minimize risk and maximize return.

Practical examples and final considerations

A classic example of the carry trade is Japan in the early 2000s, a period when the exchange rate between the Japanese yen and the U.S. dollar was nearly stable and Japan maintained extremely low interest rates. International investors exploited this opportunity by borrowing in yen and converting funds into dollars to invest in U.S. government bonds with yields above 3 percent. The strategy was highly advantageous because the interest rate differential between the two economies allowed investors to cover the cost of borrowing and generate a profit on the net return. In the carry trade, it is crucial that the exchange rate is sufficiently stable over time. Indeed, a significant fluctuation could erode or wipe out the profit margin. For this reason, the strategy is often considered only when the currencies of the countries involved have a stable exchange rate and predictable interest rates.

Carry trade and stock market collapse in August 2024

The collapse of stock markets in early August 2024 highlighted the risks implicit in carry trade, especially those related to the Japanese yen. The Bank of Japan’s decision to raise interest rates triggered significant volatility in the markets, causing many investors to liquidate their carry trade positions to avoid losses. This massive liquidation caused a rapid rise in the yen, which affected the repayment costs of yen-denominated loans. As investors sought to cover the higher costs by selling assets in other currencies, the value of those assets fell sharply, dragging the major global indices down with it. In just a few weeks, the value of the yen rose by 10 percent against the dollar, while stock exchanges such as Japan’s Nikkei and European and U.S. markets experienced substantial declines. This scenario demonstrated once again how the carry trade can amplify market volatility, especially in times of economic uncertainty.

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