Carry Trade Defined, or Why Interest Rates Matter

(Bloomberg) -- Here’s what sounds like a surefire way to improve an asset’s returns: Use cheaper money to buy it. That’s the core of what’s known as a foreign-currency carry trade. Investors take advantage of a difference in interest rates between two countries to borrow where the rate is low and invest where it’s high. Investors have employed the trade for decades to bet on currencies including the Australian dollar and the Mexican peso; a more recent strategy has been to borrow in U.S. dollars to invest in emerging markets such as Turkey and Argentina. Warning: Carry trades are a pretty good way to lose large sums of money, given that exchange rates are prone to unpredictable corrections that can force sudden, painful unwinding of investments.

1. Why is it called a carry trade?

In finance speak, the“carry” of an asset is the return obtained from holding it. So a carry trade involves buying a currency and “carrying” it until you make a profit.

2. How does it work?

According to economic theory, the strategy shouldn’t work at all. High interest rates should imply that a country has poor economic fundamentals or faster inflation, and therefore its currency should depreciate. So the difference in interest rates between two countries should reflect the rate at which investors expect the high-interest-rate currency to depreciate against the low-interest-rate currency.

3. So why does it work?

In practice, yield-hungry investors are usually prepared to overlook poor fundamentals if the reward is high enough. The carry traders themselves then help to strengthen the high-interest-rate currency by investing in it and when that starts to happen, more investors want to get involved in the trade, helping the currency advance even more. Also, the theory doesn’t always match reality. Sometimes, high interest rates come at a turning point when policy makers start to fix their economy, prompting appreciation in the country’s assets. One reason for the emergence of Turkey and Argentina as carry-trade venues is that their central banks have pushed up interest rates to cope with economic troubles.

4. Who trades?

Until the 1990s, the strategy was the realm of hedge-fund managers betting on obscure emerging-market currencies, and the term was little known in mainstream finance. Then the Bank of Japan cut its interest rates close to zero and traders across the world realized they could make a profit borrowing in yens to buy dollar-based assets. These days the strategy is the territory of investors in bonds and other fixed-income assets and trades are typically short-term, according to the Bank for International Settlements.

5. How do they do it?

The most common way to implement a carry trade is to borrow money in Country A, where interest rates are low, exchange it for the currency of Country B, where rates are high, and invest in bonds in Country B. Investors who don’t want or aren’t able to invest in local-currency bonds can access carry returns through currency swaps and futures contracts, instruments that give payouts based on exchange-rate moves over time.

Carry Trade Defined, or Why Interest Rates Matter

6. What are the returns like?

After adjusting for risk, the carry trade typically outperforms stocks. The Bloomberg Cumulative FX Carry Trade Index, which tracks the performance of eight emerging-market currencies versus the dollar, has had positive returns in 12 of the past 18 years. 

7. What can go wrong?

Economists have likened the carry trade to picking up pennies in front of a steam roller -- the money’s there for the taking, so long as you don’t dally and get crushed. Just ask U.S. hedge fund FX Concepts, which went bust in 2013 when it reacted slowly to decisions by central banks across the world to cut interest rates to virtually zero. Another good example is the yen-dollar carry trade of the late-1990s. In just one week in 1998, the yen rose 16 percent versus the dollar, reversing years of profitability for carry-trade investors who had borrowed in yen to invest elsewhere.

8. Why can trouble emerge so suddenly?

Reversals of fortune in carry trades can be triggered by a tightening of monetary policy in the low-interest-rate currency, an unforeseen event that reduces the attractiveness of the target currency or simply a realization in the market that the target currency has become detached from economic fundamentals.

The Reference Shelf

  • QuickTake explainers on central bank independence and hedge funds.
  • A Bank for International Settlements report on currency carry trades in Latin America.
  • A dummies-guide blog post on the carry trade by investor Mark Dow.
  • An economic letter published by the Federal Reserve Bank of San Francisco.
  • Economist Jeffrey Frankel explains how carry trading works and what happens when it unwinds.
  • A Bloomberg article on how carry trades have been performing well in 2019.

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