Imagine you have a friend who lives in a country where the interest rates on savings accounts are really high. You could borrow money from a bank in your country, where interest rates are low, and then send that money to your friend. They could then put it in their high-interest savings account, and you could earn a profit from the difference in interest rates. This is the basic idea behind a carry trade.

Here’s a more detailed explanation:

1. Borrowing at a low rate: A carry trade starts with borrowing money in a currency with a low interest rate. This is like borrowing money from your bank at a low interest rate.
2. Investing at a high rate: The borrowed money is then converted into another currency with a higher interest rate. This is like sending the money to your friend in the country with high interest rates.
3. Profiting from the difference: The investor hopes to make a profit from the difference between the two interest rates. This is like your friend earning a higher interest rate on their savings account than you are paying on your loan.

Example:

Let’s say you borrow 100,000 Japanese Yen (JPY) at an interest rate of 0.1% per year. You then convert this to US Dollars (USD) at an exchange rate of 100 JPY = 1 USD, giving you 1,000. You then invest this 1,000 in a US Treasury bond that pays 2% interest per year.

After one year, you will have earned 20 in interest on your bond. However, you will also owe 100JPY in interest on your loan. If the exchange rate remains the same, you will need to pay 1 USD in interest on your loan. This means you have made a profit of $19 (or 1.9% of your initial investment).

Risks:

Carry trades are not without risk. The biggest risk is that the exchange rate between the two currencies could move against you. If the JPY strengthens against the USD, you will need to pay more USD to repay your loan, potentially eroding your profits or even leading to a loss.

Key Takeaways:

• A carry trade is a strategy that involves borrowing money in a currency with a low interest rate and investing it in a currency with a higher interest rate.
• The goal of a carry trade is to profit from the difference in interest rates.
• Carry trades are risky because the exchange rate between the two currencies could move against you.

References

1. Carry Trade: Definition, How It Works, Example, and Risks
2. What is a Carry Trade?
3. Currency Carry Trade: Definition as Trading Strategy and Example

Explore More

• What are some of the other risks associated with carry trades?
• How can you hedge against the risk of exchange rate fluctuations in a carry trade?
• What are some of the factors that can affect the profitability of a carry trade?
• How do carry trades affect the global economy?
• What are some of the alternative investment strategies that you could consider instead of a carry trade?