The carry-trade operation is a trading strategy that involves borrowing an asset at a low interest rate and investing funds in an asset that provides a higher return on investment. The carry-trade operation is usually based on borrowing a currency with a low interest rate and converting the borrowed amount into another currency, while the income is either deposited in the second currency if it offers high interest rates, or transferred to assets – for example, goods, bonds or real estate – expressed in units of the second currency. The carry-trade strategy is suitable only for wealthy individuals, since it contains two main risks: the risk of a sharp decline in the prices of invested assets and the assumed risk of a foreign exchange transaction, i.e. changes in the exchange rate of the funding currency against the borrower's national currency.
Currency risk is rarely hedged in carry trade, since hedging will either impose additional costs or offset the positive difference in interest rates if currency forward transactions are used. The carry-trade strategy is popular if there is a sufficient appetite for risk, but if the financial environment changes dramatically and speculators are forced to close their carry-trade positions, this can have negative consequences for the global economy.
Example of a carry-trade operation
For example, carry-trade operations involving the Japanese yen reached a total amount of 1 trillion USD by 2007, as the yen became a favorite currency for borrowing due to almost zero interest rates. With the deterioration of the situation in the global economy that took place in 2008, the collapse of almost all asset prices led to the closure of all carry-trade operations on the yen, which, as a result, led to a fluctuation in the value of the yen by almost 29% relative to its value in 2008, and by 19% against the US dollar in February 2009.
Have you ever been tempted to take a cash advance at 0% from credit cards for a limited period of time in order to invest them in an asset with a higher yield? This is the principle of the carry-trade operation.
Many bank card issuers offer a 0% interest rate for periods of time from six months to almost a year, while requiring a symbolic upfront "transaction fee" of 1%. Therefore, we will assume that you have borrowed funds in the amount of 10,000 USD for a period of one year at 1%. Suppose you have invested this borrowed amount of funds in a certificate of deposit for a period of one year, which provides you with an interest rate of 3%. Thus, your carry-trade operation will bring you a net profit of 200 USD (10,000 USD x [3% - 1%]), or 2%.
This is not a bad profit, but let's assume that you find even better conditions for a loan and decide to play on the stock market in order to get a total income of 10%. In this case, if you open the right positions and the market helps you to make a profit, your net income would be 9%. But what happens if the market suddenly makes a correction, and your investment portfolio suffers a drawdown of 20% by the end of the year, and you will need to return the funds taken from the credit card in the amount of 10,000 USD? You will receive losses on your carry-trade operation in the amount of 2,000 USD.
Considering the same example further, let's take the case when, instead of placing funds on the stock market, you converted the borrowed amount of 10,000 USD into an exotic currency (EV) and placed funds on deposit at the interest rate of 6% offered to you. By the end of the year, if the exchange rate between the dollar and this EV remains the same, your return on investment will be 5% (6% - 1%). If this EV is strengthened by 10%, your return on investment will be 15% (5% + 10%). But if this EV becomes cheaper by 10%, your return on investment will be -5% (5% - 10%).