by Kathy Lien

The leveraged carry trade strategy is one of the favorite trading strategies of global macro hedge funds and investment banks. It is the quintessential global trade. In a nutshell, the carry trade strategy entails going long or buying a high-yielding currency or selling a shorting low-yielding currency. Aggressive speculators will leave the exchange rate exposure un-hedged, which means that the speculator is betting that the high-yielding currency is going to appreciate in addition to earning the interest rate differential between the two currencies. For those who hedge the exchange rate exposure, although interest differentials tend to be rather small, on the scale of 1 to 5 percent, if traders factor in 5 to 10 times leverage, the profits from interest rates alone can be substantial. Just think about it: A 2.5 percent interest rate differential becomes 25 percent on 10 times leverage. Leverage can also be very risky if not managed properly because it can exacerbate losses. Capital appreciation generally occurs when a number of traders see this same opportunity and also pile into the trade, which ends up rallying the currency pair.

In foreign exchange trading, the carry trade is an easy way to take advantage of this basic economic principle that money is constantly flowing in and out of different markets, driven by the economic law of supply and demand: markets that offer the highest returns on investment will in general attract the most capital. Countries are no different – in the world of international capital flows, nations that offer the highest interest rates will generally attract the most investment and create the most demand for their currencies. A very popular trading strategy, the carry trade is simple to master. If done correctly, it can earn a high return without an investor taking on a lot of risk. However, carry trades do come with some risk. The chances of loss are great if you do not understand how, why, and when carry trades work best.

How Do Carry Trades Work?

The way a carry trade works is to buy a currency that offers a high interest rate while selling a currency that offers a low interest rate. Carry trades are profitable because an investor is able to earn the difference in interest – or spread – between the two currencies.

An example: Assume that the Australian dollar offers an interest rate of 4.75 percent, while the Swiss franc offers an interest rate of 0.25 percent. To execute the carry trade, an investor buys the Australian dollar and sells the Swiss franc. In doing so, he or she can earn a profit of 4.50 percent (4.75 percent in interest earned minus 0.25 percent in interest paid), as long as the exchange rate between Australian dollars and the Swiss franc does not change. This return is based on zero leverage. Five times leverage equals a 22.5 percent return on just the interest rate differential. To illustrate, take a look at the following example and Figure 9.5 to see how an investor would actually execute the carry trade:

Executing the Carry Trade

Buy AUD and sell CHF (long AUD/CHF).

Long AUD position: investor earns 4.75 percent.

Short CHF position: investor pays 0.25 percent.

With spot rate held constant, profit is 4.50 percent, or 450 basis points.

If the currency pair also increased in value due to other traders identifying this opportunity, the carry trader would earn not only yield but also capital appreciation. To summarize: A carry trade works by buying a currency that offers a high interest rate while selling a currency that offers a low interest rate.

Why Do Carry Trades Work?

Carry trades work because of the constant movement of capital into and out of countries. Interest rates are a big reason why some countries attract a great deal of investment as opposed to others. If a country’s economy is doing well (high growth, high productivity, low unemployment, rising incomes, etc.), it will be able to offer those who invest in the country a higher return on investment. Another way to make this point is to say that countries with better growth prospects can afford to pay a higher rate of interest on the money that is invested in them.

Investors prefer to earn higher interest rates, so investors who are interested in maximizing their profits will naturally look for investments that offer them the highest rate of return. When making a decision to invest in a particular currency, an investor is more likely to choose the one that offers the highest rate of return, or interest rate. If several investors make this exact same decision, the country will experience an inflow of capital from those seeking to earn a high rate of return.

What about countries that are not doing well economically? Countries that have low growth and low productivity will not be able to offer investors a high rate of return on investment. In fact, there are some countries that have such weak economies that they are unable to offer any return on investment, meaning that interest rates are zero or very close to it.

This difference between countries that offer high interest rates versus countries that offer low interest rates is what makes carry trade possible. Let’s take another look at the previous carry trade example, but in a slightly more detailed way:

Imagine an investor in Switzerland who is earning an interest rate of 0.25 percent per year on her bank deposit of Swiss francs. At the same time, a bank in Australia is offering 4.75 percent per year on a deposit of Australian dollars. Seeing that interest rates are much higher with the Australian bank, this investor would like to find a way to earn this higher rate of interest on her money.

Now imagine that the investor could somehow trade her deposit of Swiss francs paying 0.25 percent for a deposit of Australian dollars paying 4.75 percent. What she has effectively done is to sell her Swiss franc deposit and buy an Australian dollar deposit. After this transaction she now owns an Australian dollar deposit that pays her 4.75 percent interest per year, 4.50 percent more than she was earning with her Swiss franc deposit.

In essence, the investor has just done a carry trade by “buying” an Australian dollar deposit, and “selling” a Swiss franc deposit.

The net effect of millions of people doing this transaction is that capital flows out of the Switzerland and into Australia as investors take their Swiss francs and trade them in for Australian dollars. Australia is able to attract more capital because of the higher rate if offers. This inflow of capital increases the value of the currency, see Figure 9.6.

To summarize: Carry trades are made possible by the differences in interest rates between countries. Because they prefer to earn higher interest rates, investors will look to buy and hold high-interest-rate-paying currencies.