What is a Carry Trade?
A carry trade is a type of trading or investment where you borrow money at a low interest rate. Then, you use that borrowed money to buy something else that will make more money than the interest you have to pay. The goal is to make a profit.
How Carry Trades Work
Carry trades take advantage of different prices or interest rates between two things. The trader borrows the cheaper thing and uses it to buy something more expensive that will go up in value over time.
The trader hopes to make money in two ways:
- From the difference in the borrowing cost vs. the return on the investment (the “carry”)
- From the price of the investment going up over time
As long as the first thing stays cheap to borrow and the second thing gains value, the trader can make good money. But carry trades can be risky if the situation changes.
Common Types of Carry Trades
Carry trades can be done with many different kinds of investments. Some of the most common are:
Currency Carry Trades
Currency carry trades are one of the most well-known types. Traders borrow money in a currency with low interest rates, like the Japanese yen. Then they use that money to buy a currency with higher interest rates, such as the Australian dollar.
The trader earns the difference between the low interest they pay on the yen and the higher interest they get paid on the Australian dollars. They can also make money if the Australian dollar goes up in value compared to the yen.
Bond Carry Trades
In bond carry trades, investors borrow money to buy bonds that pay higher interest rates than the cost of their loan. For example:
- Borrow at 2%
- Buy bonds paying 5%
- Earn the 3% difference as profit
The risk is that the price of the bonds could go down. Then the trader could lose money even with the interest they earn.
Stock Market Carry Trades
Some carry trades involve the stock market. Traders borrow money at low rates and use it to buy stocks they think will go up a lot in price. If the stocks gain more than the interest on the debt, the trader makes money.
Commodity Carry Trades
You can structure carry trades with commodities too. For instance, an oil carry trade might involve borrowing money cheaply to buy oil futures contracts. The trader hopes to profit from rising oil prices over the life of the futures contracts.
The Risks of Carry Trades
Carry trades can be great when they work out. But they also come with big risks. The main dangers are:
Borrowing Costs Could Rise
If interest rates go up, the cost of borrowing for the trade gets more expensive. This eats into any profits. In some cases, rising rates could turn the whole trade upside down so it loses money.
The Price of the Investment Could Fall
The success of a carry trade depends on the investment gaining value, or at least not losing value. If the price of the asset falls enough, it can wipe out the profits from the interest rate difference. The trader could end up losing a lot of money.
Exchange Rates Can Shift
In currency carry trades, changing exchange rates pose a big risk. If the currency the trader borrowed gets more expensive compared to the one they bought, it can ruin the trade.
For example, a trader borrows yen and buys Australian dollars. But then the yen rises sharply against the Australian dollar. Now all of a sudden, the trader’s yen debt is a lot more expensive in Australian dollar terms.
Leverage Amplifies Losses
Many carry trades use leverage – borrowing money to increase the size of the bet. Leverage juices profits when things go well. But it also makes losses much worse when trades go bad.
If a trade goes south, leveraged losses can be big enough to wipe some traders out entirely. The more leverage used, the riskier it gets.
When Carry Trades Go Wrong
History is full of famous carry trade meltdowns. One of the biggest happened in 2008.
Many hedge funds and investors had been borrowing money in cheap yen and investing it in higher-yielding assets around the world. It worked great for a while.
But when the financial crisis hit, investors panicked. They sold off risky investments and rushed to buy back yen to pay off their yen debts. This caused the yen to spike in value very quickly.
The rising yen caused huge losses for the Japanese “yen carry trade.” Some major hedge funds blew up as a result.
Other big carry trade losses happened in 1997 during the Asian Financial Crisis, and in 1998 around the Russian debt default.
Controversy Around Carry Trades
Some experts think carry trades can make financial markets more unstable and fragile, especially when lots of investors are doing them with leverage.
The danger is that if something bad happens, everyone will rush to unwind their carry trades at the same time. This can cause massive market moves in a short period, like a mini-crash. It can ripple across investment markets and currencies in unexpected ways.
Some economists worry that in a worst-case scenario, the fallout from carry trades going bad could destabilize the whole global financial system. Though hard to quantify, this systemic risk is a real concern for policymakers.
Attempting Carry Trades
Despite the risks, carry trades remain very popular. Many professional investors and hedge funds do carry trades all the time. They are a common part of their toolkit.
But carry trades are not for everyone. They are generally considered an advanced trading strategy. Doing them requires deep knowledge of borrowing markets and the assets involved.
Carry trades also need close attention and monitoring. The risks can change quickly as market conditions shift. For this reason, they may not be suitable for casual investors or for “set it and forget it” approaches.
As with any investment, it is important to understand the risks involved with carry trades before trying them. They are not a magic solution for easy profits. When they go wrong, the losses can be swift and severe.
But for those with the right skills and risk management, carry trades can be a way to potentially juice returns in almost any market.
