Introduction

Taking advantage of the difference in interest rates between two currencies or financial instruments is called a carry trade.

The idea is to borrow in one currency at a low interest rate and invest in another currency at a higher rate. If the exchange rate behaves, that is, the income you get from the difference in interest rates is called a "carry".

Although carry trades are profitable, an unexpected drop in currency values ​​or interest rates can turn a good trade into a bad one. The financial crisis of 2008 and Japan's monetary policy changes of 2024 are examples of how these businesses can create crises for a country. Carry trades require a clear understanding of global markets, central bank decisions and how to manage effective leverage.

What Is a Carry Trade?

Carry trade is a strategy where you borrow money in one currency at a low interest rate and invest in a different currency or asset from which you can earn a higher return. The idea is very simple: you get some profit from the difference in interest rates.

Although this strategy is mostly used in forex and currency trading, it can also be useful in stocks, bonds and even commodities.

How Carry Trades Work

You borrow in a currency that has low or near-zero interest rates, such as the Japanese yen (JPY), which has had low interest rates for several years. Then, you convert to a currency that pays a higher interest rate, like the US dollar. Now that you have the high-yield currency, you invest it in something like US government bonds or other assets that give you a good return.

For example, if you borrow yen at 0% and invest in something that pays 5.5%, you're earning that 5.5% without any fees or expenses. As long as the exchange rate is good, it tends to turn cheap money into more money.

Why Investors Use Carry Trades

Carry trades are very popular because they provide the opportunity to earn a stable return from interest rate differentials without the need to increase the value of the investment. This has made it a favorite of large investment institutions such as hedge funds and institutional investors who have the tools and knowledge to deal with risk.

Investors often use leverage in carry trades, meaning they borrow more money than they actually have. While this can make the returns huge, the losses can be just as big if the money is not invested as planned.

Examples of Carry Trades

The classic yen-dollar strategy is one of the most well-known examples of carry trades. Investors borrowed Japanese yen for years and invested that money in US assets that gave them much higher returns. As long as interest rate differentials remained favorable and the yen did not suddenly appreciate against the dollar, this was a sweet deal – which eventually happened in July 2024.

Emerging markets are another popular example. Here investors borrow in low-interest currencies and later invest in high-yielding currencies or bonds in emerging markets. Potential returns can be very high, but these trades are highly dependent on global market conditions and changes in investor sentiment. If market conditions are depressed, they can quickly go from profitable to large losses.

Risks of Carry Trades

Like any investment strategy, carry trades have risks. The biggest risk is currency risk. You may not make a profit or even suffer a loss if the currency in which you have borrowed suddenly rises in value compared to the currency in which you have invested.

For example, if you borrow currency in Japanese yen and buy USD, if the yen is strong against the dollar, you won't get that amount of yen when you switch back to yen. Interest rate changes are another risk. If the central bank raises the interest rate on the currency you borrow, your borrowing costs will increase and your profit margin may decrease. Or, if the currency in which you invest is cut by bank rates, your returns decrease.

These risks became very real during the financial crisis of 2008, especially those involving the yen, with many investors making large losses on carry trades. Changes in Japanese monetary policy in 2024 led to a strengthening of the yen, leading to trading halts and market volatility.

The Impact of Market Conditions

Carry trades tend to yield better profits when the market is stable and bullish. In these stable or bullish conditions currency values ​​and interest rates do not fluctuate much and investors are willing to take risks.

However, when the market is volatile or there is economic uncertainty, carry trades are very risky. Investors in highly leveraged and volatile markets may panic and withdraw from their carry trades, which can lead to large swings in currency prices and even widespread financial instability.

When the Bank of Japan unexpectedly raised interest rates in July 2024 and the yen appreciated, many investors quickly exited their yen carry trades. As a result, yen sold off high-risk assets to pay off debt, which not only destabilized currency markets but also triggered a global sell-off of risky investments. The effect was further amplified through leveraged positions.

Conclusion

Carry trades can be the best income way to profit from interest rate differences between currencies or assets. After that, it is important to be aware of the risks, especially in highly leveraged and volatile markets.

To succeed with carry trades, you must have a great deal of knowledge on global markets, currency movements and interest rate trends. Because you can face huge losses if the market moves unexpectedly, carry trades are suitable for experienced investors or companies to effectively manage risks.