What is a Carry Trade?
The Carry Trade is a popular trading strategy in the foreign exchange (Forex) market where investors borrow money in a low-yielding currency and invest the funds in a higher-yielding currency.
In a typical carry trade scenario, an investor borrows money in a currency with a low interest rate, such as the Japanese Yen, and then uses that money to purchase a higher-yielding currency, such as the Australian Dollar. The investor can earn a profit from the difference between the interest rates, known as the “carry,” as long as the exchange rate remains stable or appreciates over time.
Carry Trade Example
For example, if an investor borrows 1 million Japanese Yen at an interest rate of 0.1% and invests it in the Australian Dollar, which has an interest rate of 2.5%, the investor can earn an annualized return of 2.4%. If the Australian Dollar appreciates against the Yen during this time, the investor can earn additional profits.
However, carry trades are considered to be a high-risk strategy because they are vulnerable to sudden changes in exchange rates, which can lead to significant losses for investors. As a result, carry trades are often used by experienced investors and traders who have a deep understanding of the Forex market and the associated risks.
Leveraged Carry Trade Example:
Assume you borrow $1,000,000 at a 1% interest rate.
However, the bank will not simply give a million dollars to anyone. It needs $10,000 in cash collateral from you.
It’s important to remember that you’re not alone.
Your loan has been authorized, so stock up on cash.
Then you turn around and stroll across the street to another bank, where you deposit the $1,000,000 in a 5%-a-year savings account.
A year passes. What is your earning profit?
The bond paid you $50,000 in income ($1,000,000 *.05).
You paid interest of $10,000 ($1,000,000 *.01).
As a result, your net earnings is $40,000.
You made $40,000 with only $10,000!
That’s a 400% return!
Next Lesson: Carry Trade Criteria and Risk