CARRY TRADE

Definition

A carry trade is a trading strategy in which an investor borrows in a currency with a low interest rate and uses the proceeds to invest in a currency or asset with a higher interest rate, aiming to profit from the interest rate differential (the "carry").

This strategy is common in foreign exchange (FX) markets but can also apply to fixed income and derivatives.

Origins

The term "carry" refers to the cost or yield of holding an asset or position over time. Carry trades became especially popular in the late 20th century as global capital markets integrated, with Japan’s low interest rates in the 1990s making the Japanese yen a preferred funding currency.

Usage

Carry trades are used in:

• FX trading – Borrow in low-yield currencies, invest in high-yield currencies.

• Fixed income – Buy higher-yield bonds with borrowed funds.

• Equities & derivatives – Use margin loans to invest in higher-return assets.

• Commodities – Exploit futures market pricing differentials.
  
  

How Carry Trade Works

1. Select Funding Currency – Choose a currency with low interest rates (e.g., JPY, CHF).

2. Borrow Funds – Secure debt in that currency at minimal cost.

3. Convert & Invest – Convert into a high-yield currency or asset (e.g., AUD, emerging market bonds).

4. Earn Interest Differential – Profit from the difference between funding cost and investment yield.

5. Manage FX Risk – Use hedging strategies to mitigate currency fluctuations. 
   
   

Types of Carry Trades

1. FX Carry Trade

• Borrow in low-yield currency, invest in high-yield currency.

• Example: Borrow JPY → Invest in AUD.

2. Fixed Income Carry

• Borrow short-term at low rates to buy long-term higher-yield bonds.

3. Commodity Carry

• Exploit futures curve pricing, e.g., crude oil contango/backwardation.

4. Cross-Asset Carry

• Funding in one asset class to invest in a different one.

   

Key Takeaway

• Profits come from interest rate differentials.

• Main risk is exchange rate volatility—currency depreciation can wipe out gains.

• Works best in stable or appreciating high-yield currency environments.

• Widely used by hedge funds, institutional investors, and FX traders.

Context in Financial Modeling

Carry trade assumptions influence:

• Portfolio risk models – Stress test currency moves.

• Global macro strategies – Model rate differentials across economies.

• Hedging costs – Evaluate whether forward premiums erode carry profits.

• Value at Risk (VAR) – Quantify FX risk exposure.
  
  

Nuances & Complexities

• Uncovered Interest Rate Parity (UIP) – Theory suggests carry trade profits should be offset by currency moves, but this often fails in practice.

• Crisis Risk – Carry trades unwind rapidly in market stress, causing sharp FX swings.

• Leverage Impact – High leverage amplifies both profits and losses.

• Policy Risk – Central bank rate changes can instantly alter trade viability.
   

Mathematical Formulas

Unhedged Carry Trade Return:

$$R \approx (i_H - i_L) + \Delta S$$

Where:

• $i_H$ = Interest rate of high-yield currency

• $i_L$ = Interest rate of low-yield currency

• $\Delta S$ = Percentage change in exchange rate

Hedged Carry Trade Return (using FX forwards):

$$R \approx i_H - i_L$$

Since forward contracts price in the interest differential (covered interest parity).

$$\text{Overcollateralization Ratio} = \frac{\text{Collateral Value} - \text{Bond Value}}{\text{Bond Value}}$$

Related Terms

• Interest Rate Differential
  
  

• Uncovered Interest Rate Parity (UIP)
  
  

• FX Forward
  
  

• Hedging
  
  

• Leverage
  
  

• Risk Premium

Real-World Applications

Example 1: Yen Carry Trade

Borrowing JPY at 0.25%, converting to AUD at 4.5% interest. If AUD/JPY remains stable, profit ≈ 4.25% annualized.

Example 2: Emerging Market Bonds

Borrow USD at 1.5% and invest in Brazilian real bonds yielding 6.5%. Risk: BRL depreciation.

Example 3: 2008 Financial Crisis

Massive carry trade unwinds when funding currencies (JPY, CHF) appreciate sharply as investors deleverage.

References & Sources

• Investopedia: Carry Trade Definition