The carry trade is an investment strategy widely used in the foreign exchange (Forex) markets, but which can also be applied to other asset classes. This strategy involves borrowing funds in a currency with a low interest rate (or in a country with low interest rates) and investing these funds in another currency (or asset) offering a higher interest rate. In this way, the investor benefits from the interest rate differential between the two currencies .

How the carry trade works

The carry trade is based on a simple principle: take advantage of interest rate differentials. Here’s how it usually works on currency markets:

1. Borrowing in a low-interest currency: The investor borrows money in a currency with a very low interest rate. For example, if the interest rate in Japan is low (which is often the case with the Japanese yen), the investor could borrow yen.
2. Investment in a high-interest currency: The investor converts these borrowed funds into another currency offering a higher interest rate. For example, he could invest these funds in bonds or deposits in Australian dollars, a currency with a higher interest rate.
3. Cashing in on the interest-rate differential: The investor benefits from the interest-rate differential between the two currencies. If he borrows at 0.5% in Japan and invests at 5% in Australia, he can theoretically make a profit of 4.5% on the spread, regardless of exchange rate fluctuations.

Examples of carry trade currencies

Historically, certain currencies are often used in carry trade strategies:

• Japanese yen (JPY): Due to extremely low interest rates in Japan, the yen has often been used to finance carry trade positions.
• Swiss franc (CHF): The Swiss franc is also used as a borrowing currency, given the Swiss National Bank’s historically low rates.

These low-rate currencies are then used to invest in higher-yielding currencies, such as the Australian dollar (AUD), New Zealand dollar (NZD) or pound sterling (GBP), depending on economic conditions.

The advantages of the carry trade

1. High potential returns: If the carry trade strategy performs as expected, it can generate significant returns, particularly in an environment where interest rate differentials are large and stable.
2. Conceptual simplicity: The logic of the carry trade is relatively simple: borrow at low cost and invest at a higher rate.
3. Leverage: As the strategy often involves borrowing to invest, investors can use leverage to amplify their returns. However, this can also increase risk (see below).

Carry trade risks

Although the carry trade can offer attractive returns, it also involves several significant risks:

1. Currency risk: The main risk of the carry trade is linked to fluctuations in exchange rates. If the currency in which the investor has borrowed (funding currency) appreciates against the currency in which he or she has invested, the investor may suffer losses. For example, if the investor has borrowed in Japanese yen and invested in Australian dollars, a strong appreciation of the yen against the Australian dollar could erode the gains linked to the interest rate differential.
2. Leverage: Using leverage, i.e. borrowing funds to invest, can amplify gains, but also losses. If exchange rates move unfavorably, losses can be multiplied, making the position very risky.
3. Liquidity risk: In times of financial market stress, investors may seek to rapidly liquidate their carry trade positions, leading to increased currency volatility and a rapid decline in the prices of the assets in question.
4. Changes in monetary policy: The carry trade strategy relies on relatively stable interest rate spreads. If a central bank decides to rapidly raise interest rates in a country where the currency is used to borrow, this can reverse the trend and lead to losses.

Impact of financial crises on the carry trade

The carry trade is particularly vulnerable in times of economic or financial crisis. For example, during the 2008 financial crisis, many investors who had borrowed in Japanese yen to invest in riskier assets had to liquidate their positions quickly. This triggered a sudden rise in demand for yen, leading to a sharp appreciation of the yen and substantial losses for investors involved in the carry trade.