FX carry trade, also known as currency carry trade, is a financial strategy whereby the currency with the higher interest rate is used to fund trade with a low yielding currency. Using the FX carry trade strategy, a trader aims to capture the benefits of risk-free profit-making by using the difference in currency rates to make easy profits.
FX carry trade stands as one of the most popular trading strategies in the foreign exchange market. The most popular carry trades involve some widely used currency pairs in the forex market such as the Australian dollar-Japanese yen pair and the New Zealand dollar-Japanese yen pair. The interest rate spreads of the currency pairs are known to be quite high. FX trade follows the principle of “buy low, sell high.”
FX carry trade, also known as currency carry trade, is a financial strategy whereby the currency with the higher interest rate is used to fund trade with a low-yielding currency.
FX carry trade stands as one of the most popular trading strategies in the foreign exchange market.
FX trade follows the principle of “buy low, sell high.”
FX Carry Trade Working Model
A trader involved in an FX carry trade aims to make a profit off of the difference in the interest rates of the currencies of two countries, as long as the exchange rates do not fluctuate significantly. The funding currency is the currency that is being traded in or being exchanged in a currency carry trade transaction. It typically comes with a lower interest rate.
Investors execute an FX carry trade by borrowing the funding currency and taking short positions in the asset currencies. The central banks of the funding currencies usually use monetary policies to lower interest rates in order to facilitate growth during times of recession. As the rates fall, investors borrow money and invest them by taking short positions.
Say, for example, a trader notices that the rate of the Japanese yen is 0.5%, while the rate of the Australian dollar is 4%. The trader aims to make a profit of up to 3.5%, being the difference between the two rates. He will then carry an FX carry trade by borrowing Japanese yen and converting them into Australian dollars. The trader will then invest the dollars into a security that pays the AUD rate.
After the maturity of the investment, the trader will then reconvert the investment proceeds back to the Japanese yen, with the intention of making some risk-free profit by using the interest rate spread between the two currencies. If the exchange rate moves against the yen, the trader will profit even more. However, if the yen got stronger, the trader would have earned less than the 3.5% interest spread or might have even incurred a loss.
Risks Associated with an FX Carry Trade
1. Uncertainty in exchange rates
The biggest risk in an FX carry trade is the uncertainty of exchange rates. It is because the forex market is an exceptionally volatile one, and can change its course at any point in time. Using the example below, if the AUD were to fall in value relative to the Japanese yen, the trader would’ve incurred a massive loss. Hence, a small movement in exchange rates can result in massive losses.
If the country of the investing currency reduces interest rates, and the country of the funding currency increases its interest rates, it will result in a loss of positive net interest rate, and hence will reduce the profitability of the FX carry trade.