In this article, we are going to define the meaning of Currency Carry Trade. This is a strategy, in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency, producing higher interest rate. The trader, who uses this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of the employed leverage.
Let’s go into an example of a „yen carry trade”- trader loans 1.000 Japanese yen from the Japanese Bank, converts the funds into U.S. dollars and buys bonds with equivalent amount. Suppose that the bonds have yields 4.5% and the Japanese interest rate is set at 0%. The trader keeps making profit of 4.5%, while the exchange rate between the countries does not change. Many professional investors use this trade, because the earnings could become very high, when the leverage is taken into account. If the trader in our example uses a common leverage ratio at 10:1, then he can stand to make a profit of 45%.
The high risk in carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar falls in its value against the Japanese yen, then the trader would be at risk of losing money. Besides, these transactions are typically made with big leverage, so the small movements in exchange rates can result in huge losses, unless the position is hedged appropriately.