Carry Trade Definition. How Does it Work?

Carry trade is a well-known method of trading in the forex market. However, inexperienced investors seem to have mixed feelings about this trading style. Is it because they don’t like the strategy? Or may it be due to the fact that they don’t know what carry trade is? Luckily for you, in this article, we will explain how carry trade works. So, let’s get started.

What is a Carry Trade?

As we mentioned, carry trade is a well-known investment strategy. Carry trade refers to a trading strategy that consists of two phases. First, you borrow in a low-interest rate currency. Then, you convert the borrowed amount into another currency that provides a higher return.

In other words, a high-yielding currency funds the trade with a low-yielding currency and tries to attempt the difference between the rates. These rates can often be substantial, all about depending on the amount of leverage used.

The carry trade is an essential trading strategy in the forex market. The famous most carry trades are the Australian dollar/Japanese yen and New Zealand dollar/Japanese yen. It is because the rate of interest spreads of these currencies have been too high.

How Carry Trades Works?

Carry trade is when you borrow a currency with a low-interest rate. After that, you use that money to buy another currency that pays a higher interest rate. You can make money on the difference between the interest rates.

To see the interest rates for each currency, you can take a glance at any up-to-date list of central bank interest rates. For instance, if you did the process of carry trading where you borrowed Swiss Francs and bought U.S. Dollars, you will be making a rollover. In other words, you would be making money on the interest due to the fact that the interest rate of the Federal Reserve is higher than the interest rate of the Swiss National Bank.

Moreover, how does a 0% cash advance offered by credit card issuers for limited periods sounds to you? The purpose is the investment in an asset with a higher yield. Well, that’s what carry trade does. However, carry trade comes with risks. Therefore, it is not for everyone. Traders who want to give carry trading a try should be able to stomach the stress and risks.

What is the Japanese Yen Carry Trade?

Well, the Japanese Yen carry trade refers to a trade where you borrow Japanese Yen. Moreover, most investors buy higher interest rate currencies – for example, the U.S. Dollar.

This trade was trendy and famous in the early 2000s.  Moreover, by the end of 2007, the Japanese yen carry trade has reacher $1 trillion. Thanks to the near-zero interest rates, the Japanese yen carry trade became extremely popular.

When to Get in a Carry Trade

If you want to try this strategy, you are probably wondering whether there is a right time to get in a carry trade. As currency carry trade is a process in which high-yielding currency funds the trade with a low-yielding currency, there is a right time to get in and to get out. 

Generally, the best time to get in is when central banks are raising interest rates. As carry trade has proven to be extremely popular, the number of people just keeps growing. Of course, these trades work well during times of low volatility. It happens because traders are agreed to take on more risks.

Risks and Limitations of Carry Trades

The most significant threat in a carry trade is the uncertainty of exchange rates. Let’s see an example. As we mentioned earlier, you have already borrowed Swiss Francs and bought U.S. Dollars. Unless the price goes down, you will be making a rollover. However, if the U.S. dollar falls in value, you will probably lose money.

Further, these transactions are done with a lot of leverage. In other words, even the slightest movement in exchange rates can result in huge losses until the position is adequately hedged. Moreover, the current value of the interest rate is important. However, the future direction of interest rates is essential. Carry trades work properly when the markets are optimistic and daring.

There are always risks involved when it comes to trading. That’s why investors should be prepared for everything. Also, many experts in this field suggest that only wealthy people should go for a carry trade due to high-risks, such as a sudden decrease in price value. Also, the exchange risk is a factor. So, if you are a young, inexperienced investor, it would be wiser to try a different strategy. However, if you are willing to risk your money, you might be able to make a profit when you use this strategy.