Getting a lift from the carry trade

Correctly assessing the risk environment paves the way to capitalizing on the interest-rate differentials between currencies. BY KATHY LIEN

Just as markets that offer the highest returns will attract the most volume, so, too, 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.

The “carry trade” is a forex strategy based on this reality. Although it is particularly popular among global macro hedge funds, it is actually very simple to understand and execute. Carry trades involve buying (or lending) a currency with a high interest rate and selling (or borrowing) a currency with a low interest rate. With lackluster equity market performance and progressively lower yields from the U.S. bond market as a result of interest rate cuts by the U.S. Federal Reserve, this strategy’s popularity surged in 2002. As money piled into carry trades, unhedged traders enjoyed earning yield and capital appreciation.

If executed correctly, an investor can earn a high return without taking on excessive risk. However, the chances of loss are great if you do not understand how, why and when carry trades work best.

How do carry trades work?
Traders looking to “earn carry” will buy a high-yielding currency while simultaneously selling a low-yielding currency. Carry trades are profitable because an investor is able to earn the difference in interest (the spread) between the two currencies as well as, ideally, capital appreciation. Table 1 lists the interest rates of several major countries as of Sept. 22.

Interest rate
New Zealand (NZD)
Australia (AUD)
United Kingdom (GBP)
Canada (CAD)
Europe (EUR)
United States (USD)
Japan (JPY)
Switzerland (CHF)
*As of Sept. 22, 2004

The reason this trade is so popular is because it’s not limited to speculators.Imagine you are an investor in Switzerland who is earning an interest rate of 0.75-percent per year on your bank deposit denominated in Swiss francs (CHF). At the same time, a bank in Australia is offering 5.25 percent per year on a deposit denominated in Australian dollars (AUD). Seeing that interest rates are much higher at the Australian bank, wouldn’t you want to convert your Swiss francs into Australian dollars?

Large investors who are able to move money freely across borders will take advantage of higher yields offered abroad. By trading their deposit of Swiss francs paying 0.75 percent for a deposit of Australian dollars paying 5.25 percent, what these investors have effectively done is “sell” their Swiss franc deposit, and “buy” an Australian dollar deposit.

After this transaction they now own an Australian dollar deposit that pays 5.25 percent in interest per year — 4.50 percent more than the Swiss franc deposit. This is a carry trade. The net effect of millions of people doing this transaction is that capital flows out of Switzerland and into Australia as investors take their Swiss francs and trade them for Australian dollars. Australia attracts more capital because of the higher rates it offers.

This capital inflow increases the value of the currency Aside from earning the 4.50- percent interest rate differential, traders engaging in such unhedged carry trades are also hoping, as in this example, their Australian dollar deposits appreciate in value against the Swiss franc.

Let’s look at another example. Assume the British pound (GBP) offers an interest rate of 4.75 percent, while the Swiss franc offers an interest rate of 0.75 percent. To execute the carry trade, an investor buys the British pound and sells the Swiss franc — or, buys the GBP/CHF currency pair (see Figure 2). In doing so, he or she can earn a profit of 4 percent (4.75 percent in interest earned minus 0.75 percent in interest paid), as long as the exchange rate between the British pound and Swiss franc remains stable.

The leveraged carry trade
Now, a 4-percent annualized yield may not sound very attractive, but when you factor in leverage, the profits are noticeably higher (as are the risks). Although many FX firms offer up to 200:1 leverage, we will look at a more conservative example that employs 20:1 leverage.

Let’s say you have $5,000 to invest and decide to put $1,000 of that into a carry trade. The original 4.75 percent yield would earn you $47.50 over the course of the year or approximately $0.13 per day. With 20:1 leverage, the buying power of your $1,000 becomes $20,000. Interest then becomes $950 per year or $2.64 per day on the original investment — a return of 95 percent. Now here is where we insert the caution statement: This scenario works only if the underlying values of the currencies do not move — which of course is not possible. Currency values fluctuate every second. Therefore, using higher leverage also means you incur the possibility of larger losses.

For example, instead of a 10-pip (or point) fluctuation in the euro-U.S. dollar rate (EUR/USD) representing $1, 20:1 leverage magnifies it to $20 — and currencies will fluctuate dramatically. Between September 2003 and July 2004, the Australian dollar strengthened nearly 15 percent against the U.S. dollar (see Figure 3, p. 7). If you factor in the currency appreciation and interest rate return on leverage, the profits can be sizeable. However, 15 percent depreciation could have just as easily occurred, which would significantly hurt a leveraged trade.

Because most traders engaging in this type of strategy are looking to earn both yield and the appreciation of the currency pairs, the next question is, how do you determine the type of environment in which carry trades will
perform well?

When will carry trades work best?
Carry trades generally are most profitable when investors as a whole have a very specific attitude toward risk. Psychology drives the markets and people’s moods tend to change over time. Sometimes they may feel more daring and willing to take chances, other times they may be more timid and conservative. Investors, as a group, are no different. Sometimes they are willing to make relatively high risk investments, other times they are morefearful and seek safer assets. 

When investors as a whole are willing to assume risk, we say they have low risk aversion, or, in other words, they are comfortable taking risk. When investors re drawn to more conservative investments and are less willing to take on risk, we say they have high risk aversion (see Table 2).


Carry trade profitability


High risk aversion
Low risk aversion

Investors are less willing to take risks; they remove funds from risky currencies.
Investors are more willing to take risks.

Capital flows out of riskier high-interest currencies and into low-interest, “safe-haven” currencies
Capital flows away from low-interest currencies and into those that pay higher interest rates

Low-interest currencies appreciate as investors get out of risky trades
Low-interest currencies tend to remain weak, and are used to finance risky trades.

Source: FXCM

Carry trades are most profitable when investors have low risk aversion, which makes sense when you consider what a carry trade involves. When buying a currency with a high interest rate, the investor is taking a risk — there is uncertainty about whether the country’s economy will continue to perform well and be able to pay high interest rates.

Countries with better growth prospects can afford to pay higher interest rates on the money that is invested in them, but there is always a chance something might change. Ultimately, investors must be willing to take this chance. If investors as a whole were not willing to take on this risk, then capital would never move from one country to another, and the carry-trade opportunity would not exist.

Other considerations
While risk aversion is one of the most important things to consider before making a carry trade, it is not the only one. Here are some additional issues to take into account.

Low interest rate currency appreciation: Even if market participants are in risk-seeking mode, there are factors that can lead to a rally in the currency with the lower interest rate. When the low interest rate currency in a carry trade (the currency being sold) appreciates, it negatively affects the profitability of the carry trade.

For example, geopolitical risks or fears of terrorism tend to have a positive affect on the Swiss franc, which is widely considered the “safe-haven” currency. In Japan, although interest rates are low, increased optimism about the Japanese economy has recently led to an increase in the Japanese stock market.

Increased investor demand for Japanese stocks and currency has caused the yen to appreciate, and this yen appreciation negatively affects the profitability of carry trades such as the Australian dollar (high interest rate) vs. Japanese yen.

Trade balances: Trade balances (the difference between a country’s imports and exports) can also affect the profitability of a carry trade. When investors have low risk aversion, capital will typically flow from the low interest rate paying currency to the high interest rate paying currency. However, this does not always happen.

To understand why, consider that even though Japan currently pays historically low interest rates, there is strong demand for the Japanese yen. Although this can be attributed partially to the country’s recent recovery, a more important factor is Japan’s huge trade surplus. There is strong foreign demand for Japanese goods — electronics, cars, etc. As a result, although the country offers low rates of return, Japan attracts trade flows into the yen. The point is that even when investors have low risk aversion, large trade imbalances can cause a low interest rate currency to appreciate.

Time-horizon: In general, a carry trade is a long-term strategy. Before entering into a carry trade, an investor should be willing to commit to a time horizon of at least six months. This commitment helps to make sure the trade will not be affected by the “noise” of shorter-term currency price movements.

When to close the carry trade
Because carry trades are least profitable when investors are highly risk averse, traders who already have carry trades must stay abreast of the risk environment and prepare for when it changes.

Investors’ willingness to make risky trades can change dramatically from one moment to the next. Often such large shifts are caused by significant global events. When investor risk aversion does rise quickly, the result is generally a large capital inflow into low-interest rate, “safe-haven” currencies.

Such conditions can set the stage for carry trades to lose money. For example, in the summer of 1998 the Japanese yen appreciated against the dollar by more than 20 percent in two months, mainly because of the Russian debt crisis and the LTCM hedge-fund bailout. Similarly, just after the Sept. 11, 2001, terrorist attacks, the Swiss franc rose by more than 7 percent against the dollar over a 10-day period.

Bottom line
The leveraged carry trade strategy is still very popular in the currency markets. By properly assessing the risk environment, traders can increase the probability of successfully executing the carry trade strategy.

Kathi Lien –