A carry trade is effectively a return that an investor generates for holding, or carrying, an asset such as a currency or commodity for a period of time. It doesn’t rely on the appreciation of the asset, although that can play a role in the trade’s risk.
In a carry trade, an investor will borrow in a low interest-rate currency to buy a currency or asset earning a higher interest rate. Carry trades are one of the most traded strategies in foreign currency investing. But it’s also a high-risk strategy and requires the right market conditions and investment expertise to execute successfully.
What are common carry trades?
Popular foreign currency carry trades include trading the Australian dollar and Japanese yen or the New Zealand dollar and Japanese yen because of their high interest-rate spreads. An investor can borrow in Japanese yen, effectively pay 0% interest, while buying New Zealand or Australian dollars, earning 3.50% and 2.85%, respectively, at prevailing rates, minus trading fees and applicable costs. The final difference is the profit of the trade.
What are some of the risks?
Primary trading risks include volatile currencies or changes in interest rates. For example, emerging markets offer higher interest rates but also have high country and political risks that can cause sudden currency volatility or depreciation, leading to substantial losses in carry trading. Not only are emerging-market currencies more volatile, but the magnitude of the volatility can often be larger than that experienced in developed markets, possibly resulting in greater daily losses. The Turkish lira has been one of the most volatile emerging-market currencies in recent years: Over the 12 months from November 16, 2021, through November 15, 2022, the lira went from trading at –2.71% to the U.S. dollar to –45.92%, which included a drop of 27.10% over a period of less than one month. Currency exchange rate fluctuations and interest-rate risk are the two biggest risks in currency carry trades.
Emerging-market central bank rates
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Which investment strategies use carry trading?
Carry trading can be a high-risk strategy; Therefore, it requires expert risk management to minimize the potential for large losses. Alternative investment strategies, including global macro funds and other hedge funds, use carry trading and may combine it with positions that can also take advantage of the momentum in exchange rate movements. Beyond alternative investments, a range of other investment strategies may use carry trades too. Managers undertake extensive research and fundamental analysis, formulating views on central bank policy and country-specific and global macroeconomic drivers. It’s important to choose a skilled investment manager, especially when considering complex investment strategies. While carry trading is often used within currency markets, it’s a trading style that’s also executed across commodities, fixed-income, and equity markets.
Portfolios that have a greater percentage of alternatives may have greater risks. Diversification does not guarantee a profit or eliminate the risk of a loss. Past performance does not guarantee future results.