Understanding A Forex 'Carry Trade'

Posted by Nick Niesen on October 29th, 2010

Recently, the breakdown of the "yen carry trade" has graced the front page of major financial newspapers and business magazines. But what is a "carry trade" and how does it affect the forex? More importantly, how can you, as an individual investor, profit from carry trades? This article endeavors to provide the answers.

What is a Carry Trade?

First, it is important to remember that each forex trade is actually the simultaneous buying of one currency and selling of another. As a result, you end up receiving interest on the currency you purchase, and paying interest on the currency you sell. A carry trade takes advantage of this by seeking out high-yielding currencies to purchase while simultaneously selling low-yielding currencies -- allowing the trader to pocket the difference in interest rates.

For example, if you had purchased U.S. dollars with Japanese yen a few years ago, you would have received around 4% interest on your U.S. dollars, while paying out less than 1% on your yen. This would be a net profit of 3%, which, given the huge leverage of forex trades, could add up to a lot! Alternatively, if you did the trade the other way -- buying yen and selling U.S. dollars -- you would be at a net loss of 2%.

'Breakdown' of the Carry Trade

It's important to note that most forex brokers require a minimum margin to earn interest on carry trades -- you can't benefit from the typical 100:1 (or greater) margin; 10:1 is more common. Still, 3% net interest at 10:1 margin would result in gains of 30% just for holding the position. But is the carry trade a "sure thing?" Far from it.

The carry trade breaks down when the low-yielding currency appreciates against the high-yielding one. For example, as the yen became more valuable and the dollar lost its purchasing power, the yen-for-dollar strategy fell apart. Even though the net interest gain may have been 3%, this was cancelled out by movements in the underlying value of the currencies. Thus, a carry trade is by no means a risk-free investment or a "sure thing" -- there's never a sure thing in the financial world.

What Makes Currencies Appreciate/Depreciate?

In the example above, the carry trade "broke down" because the yen appreciated against the dollar -- meaning progressively fewer yen were needed to purchase one U.S. dollar. But why did this happen? There are several reasons one currency appreciates or depreciates versus another, including:

Unemployment (appreciate) or over-employment (depreciate)

Central banks cutting (depreciate) or hiking (appreciate) interest rates

Running trade or budget surpluses (appreciate) or deficits (depreciate)

Major macroeconomic events -- like terrorist attacks, wars, major changes in political leadership, etc.

For these reasons, carry trades are best executed between two currencies backed by stable governments. Of course, the U.S. dollar and the yen fit this description, and even their carry trade broke down. This just goes to show that there's never a sure thing in the world of high-stakes finance, and the forex market is certainly no exception. But where there is uncertainty and risk, there are also opportunities to profit. If you're willing to seek them out, then the carry trade can be one strategy in your trading arsenal.