What is a Carry Trade?

Earlier this month there was a relatively quick drop in several market indices and a rise in the volatility index, known as the VIX. Financial news outlets quickly began writing that the cause of the market drop and spike in volatility was caused, at least in part, due to an unwinding of “the Yen carry trade”. This probably leaves you wondering, what is a carry trade?

A carry trade is a financial strategy where an investor borrows funds at a low-interest rate and invests those funds in an asset or currency that provides a higher return. The investor profits from the difference between the interest paid on the borrowed funds and the interest or return earned from the investment.

How Carry Trades Work

1. Borrowing in a Low-Interest Environment:
   • The investor takes out a loan in a currency or asset where interest rates are relatively low. For example, borrowing in Japanese Yen.
2. Investing in a High-Interest Asset or Currency:
   • The borrowed funds are then invested in an asset or currency that offers a higher return. For instance, the investor might convert the borrowed Yen into US dollars and invest in US government bonds, which currently offer higher interest rates than Japanese bonds.
3. Earning the Spread:
   • The profit comes from the spread between the low cost of borrowing and the higher returns from the investment.

Example of a Currency Carry Trade

• Borrowing in a Low-Yielding Currency: Suppose an investor borrows Japanese yen at a 0.5% interest rate.
• Investing in a High-Yielding Currency: The investor then converts the yen into U.S. dollars and invests in U.S. bonds yielding 3%.
• Earning the Carry: The investor earns the difference between the 3% earned from the U.S. bonds and the 0.5% paid on the yen loan, resulting in a 2.5% profit, assuming stable exchange rates.

Risks of Carry Trades

Carry trades can be profitable, but they come with significant risks, especially related to currency fluctuations and interest rate changes:

1. Currency Risk:
   • If the currency borrowed (e.g., yen) appreciates against the currency invested (e.g., U.S. dollars), the investor could lose money when converting the investment back to repay the loan.
2. Interest Rate Risk:
   • If the interest rates in the low-yielding currency increase, the cost of borrowing rises, reducing the profitability of the carry trade.
3. Market Volatility:
   • Carry trades can be disrupted by global market volatility, which may cause large and sudden reversals in currency values.

Why Carry Trades are Popular

Carry trades are popular because they can generate returns even in relatively low-return environments. They are especially common in the foreign exchange (forex) markets, where traders exploit differences in interest rates between countries. However, the potential gains are balanced by the risks of unfavorable currency movements or changes in economic conditions.

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