A carry trader is basically an investor who involves himself in a trading strategy which is known as “Carry Trade”. A carry trader borrows money in a currency with a low interest rate and then invests it in that asset which offers him higher returns. A carry trader benefits himself from the difference between these rates. As the sole purpose of a carry trader is to get maximum benefits, he has an open choice of investing either in a different currency or a suitable asset. This trading strategy, to get benefits, is widely used in forex and currency trading. This technique can also be used in cryptocurrencies, bonds, stocks and commodities too.
How Do Carry Trades Work
Normally a trader takes out a loan in a currency which has low or near-zero interest rates. For example, Japanese yen (JPY) is known for its low interest rate for last few years. In the next step, he converts that money into that currency which has a higher interest rate. As the US dollar holds higher interest rates, he has an option to convert his money into US dollar in order to get a good return.
Carry Trade is basically a strategy which is used to change cheap money into more money. For example, if someone borrows yen at 0% and then invests it into that currency which has higher interest rates, he is earning 5.5% without any fees or cost.
Why do Investors Use Carry Trade
The big players in trade do use the strategy of Carry Trade to get good returns. Although it is risky, the institutional investors do have certain tools to manage such a big risk. They have awareness of the ups and downs of the market so they can invest without any danger or fear in their minds.
Carry Trades provide a steady return from the interest rate difference. Investors have keen observation, and this very quality makes them able to read between the lines. They can easily see what others ignore in studying the flow of the market. In this way they always try to manage their investment so that it may never go up.
Carry Traders use leverage in carry trade which means that the investors take much more loan than they actually have. In this way, the investors can get maximum benefit from the difference in rates, but this can also be risky at times. The planning of the investors can go wrong. At times, their decisions are not up to the mark or they are unable to see beneath the surface and take wrong decisions at the crucial time. Instead of getting more benefits, they may get more loss just because of an absurd decision of taking much more loan.
Examples of Carry Trades
Investors have been using the yen-dollar strategy for years. Carry traders used to borrow Japanese yen and then invested that money in US assets in order to get good returns. This became a habit for the investors as this was the simplest and the easiest way to get higher returns. This strategy was advantageous as long as the interest rates remained low. In the case of the yen, this strategy was favourable for the investors because the value of yen did not increase against US dollar. But in 2024 the value of the yen increased in the face of the dollar.
Another famous example involves Emerging markets. Here again the investors borrow in low-interest currency and then again invest in higher-yielding currencies from emerging markets. These trades are highly risky and sensitive as the value of a currency can go up at any time. Carry traders’ feelings will definitely get changed when they see a drop in higher-yielding currencies.
Carry Trades are Highly Risky
Carry trades are highly sensitive and risky in nature. At times, borrowed currency can become more valuable as compared to the currency you invested in. investors’ profits can be turned into losses when there occurs a shift in borrowed versus invested money.
If someone borrows JPY and buys US dollars, he expects a great return in this regard. If JPY gets stronger in face of US dollars, he definitely will face losses in this regard. Simply we can say that if the borrowing cost goes up, it can be highly risky for the investors.
In 2024, when monetary policy changed, many investors had to bear losses because those changes did strengthen the yen in the face of US dollar. At that time, the carry trade strategy did face a downfall and there came an instability in the market.
The Impact of Market Conditions on Carry Trades
Carry traders should invest only when the market is stable and optimistic. Usually, in such conditions interest rates do not get changed and the investors get maximum benefit in such conditions. If there occurs economic uncertainty, carry trades become very risky and fast. Investors get panic and they start losing their investment.
In July 2024, when Bank of Japan raised interest rates, investors started selling high-risk assets to repay yen loans. This greatly influenced people’s rash decisions which they took after this mishap. The impact was so great that it shattered global markets and people were so fearful that they stopped taking risk of investing in riskier investments.
Conclusion
Although carry trades are advantageous but at the same time they are risky. We always should take calculated risks. Before making any investment we always should take an overview of the current market. In order to be successful in currency trades, we should have knowledge of interest rate trends and currency movements. Moreover, institutions and veteran investors have better ideas of the market trends that’s why they can manage anything efficiently.
Frequently Asked Questions
What is a carry trade?
A carry trade is a financial strategy where investors borrow funds in a currency with a low interest rate and invest them in assets denominated in a currency with a higher interest rate, aiming to profit from the difference, known as the "carry." This approach is commonly used in forex markets but can also apply to other asset classes like bonds, stocks, and commodities.
How do carry trades work?
In a typical carry trade, an investor borrows money in a currency with low or near-zero interest rates, such as the Japanese yen. The borrowed funds are then converted into a currency offering higher interest rates, like the US dollar. The investor earns the difference between the borrowing cost and the return on the investment, potentially profiting from both the interest rate differential and any favorable currency movements.
Why do investors use carry trades?
Investors employ carry trades to generate steady returns from interest rate differentials. Institutional investors, in particular, utilize this strategy to capitalize on market inefficiencies, leveraging their market insights and risk management tools. While carry trades can offer attractive returns, they also involve significant risks, especially when market conditions change unexpectedly.
