Carry trade is a financial strategy in which an investor borrows money at a low-interest rate and invests it in an asset that provides a higher return. The objective is to profit from the difference between the interest rates, known as the “interest rate differential.” This strategy is commonly used in the foreign exchange (forex) market, but it can also apply to other types of investments such as bonds or equities.

Here’s how it typically works:

  1. Borrowing at a Low-Interest Rate: The investor borrows funds in a currency or market where the interest rates are relatively low. For example, borrowing in Japanese yen (JPY) when Japan’s interest rates are low.

  2. Investing in a High-Interest Rate Asset: The borrowed funds are then converted and invested in a different currency or market where the interest rates are higher. For example, investing in Australian dollars (AUD) or bonds that offer higher returns.

  3. Earning the Interest Rate Differential: The investor earns returns from the high-interest rate asset while paying a lower interest rate on the borrowed funds. The profit comes from the difference between the returns earned and the interest paid.

Example

An investor borrows $1 million at an interest rate of 1% and converts it into another currency to invest in an asset that yields 5%. The investor earns 5% on the investment and pays 1% on the borrowed amount, resulting in a net profit of 4% (before considering any transaction costs or currency exchange risks).

Risks

While carry trades can be profitable, they also come with significant risks:

  • Exchange Rate Risk: Fluctuations in currency exchange rates can affect the profitability of the trade. If the currency in which the investor has invested depreciates, the returns may be reduced or even turn into a loss.
  • Interest Rate Risk: Changes in interest rates can impact the carry trade. If the borrowing costs rise or the returns on the investment decline, the profit margin will decrease.
  • Leverage Risk: Carry trades often involve high leverage, amplifying both potential gains and losses.

Despite these risks, carry trades remain a popular strategy among investors seeking to capitalize on interest rate differentials across different markets.