Carry Trade | Explained in simple words

The most common notion of carry trades is the one of currency carry trades. It describes an investment strategy that tries to exploit global differences in bond yields and credit interest rates. Carry trades are similar to the principle of arbitrage, but are in fact a risky strategy as will be explained later on. If markets were functioning perfectly, carry trades would be a zero-sum game. In practice, they can be profitable and exploit long-term currency adjustments.

So what is a carry trade? The concept is best illustrated with a simple example. Say, the interest rate on a commercial loan in the United States is 2%. Assume further, the bond yield in Australia is 5%. A carry trade simply exploits the difference in the two rates. An investor takes out a loan in U.S. dollar and exchanges the money into Australian dollar and buys bonds with the cash obtained. All other things equal, the carry trade yields 3% without any capital bound.

In theory, the story does not end here. As many investors know about this strategy they will gradually cause a change in the exchange rate of the two currencies. Not only carry trades but also simple investments in the more attractive Australian dollar will increase demand for the Australian currency. As a result, the U.S. dollar will decline in value and investors having taken out a loan will further profit as they get more U.S currency for their Australian counterpart. So they might profit twice from the carry trade.

However, this is by no means a guaranteed scenario. There are many factors that can influence currencies. Further reading about the determinants of currency rates might be of interest. In case the opposite happens and the Australian dollar weakens for any kind of reason, carry trades can face substantial losses. Investors still have to serve their debt denoted in U.S dollar but they need more Australian dollars to do so in that case.

It has also become common practice in certain smaller economies to finance houses with taking out debt in foreign currencies that lure with lower interest rates. The recent cases of Iceland and Hungary make the dangers of such investments apparent. Carry trades can be a risky investment if volatility in currency exchange markets increases and this tool should be left to investors who can exactly evaluate the modalities of carry trades and more important, are able to cope with the potential losses.