Understanding Currency Carry Trades
There are many different types of assets to choose from when investing. The most common are stocks and bonds, but there are other types of assets for the more advanced trader, like commodities and currencies. Investing in stocks, bonds and even commodities is relatively simple. As an investor, you purchase the asset with the expectation that it will will rise in value over time. But currencies don’t appreciate in a vacuum. Investing in currencies means understanding one currency’s value relative to another currency and profiting from the difference.
One of the most common ways to invest in currencies in known as the currency carry trade. A detailed knowledge of interest rates and yields of two or more countries is necessary to initiate a currency carry trade, making it an investment strategy for the more experienced trader.
The Currency Carry Trade in Detail
In order to execute a currency carry trade, an investor must first short sell a currency with a low interest rate and purchase a currency that carries a higher interest rate. The difference in rates is where profits are made and leverage can be utilized, making it a very lucrative, risky trade.
Exchange rates fluctuate on a daily basis, which adds to the risk of a currency carry trade. Profits can go up or down rather quickly depending on how the exchange rate moves. Considering that leverage of 10-to-1 or even higher is usually used, this trade can result in large gains or losses in a short amount of time.
Let’s walk through an example to illustrate how a currency trade might work.
A trader decides to initiate a currency carry trade between the Japanese yen where rates are at 1% and the U.S. dollar, where rates are at 5%. The difference of 4% between the two rates is where the trader expects to profit.
To start, the trader must first sell yen and transfer it to U.S. dollars. Assuming that the exchange rate is 100 yen to 1 U.S. dollar and they wanted to short $100 million yen, this would result in $1 million U.S. dollars.
After one year of being invested in the dollar at a 5% rate, the trader would have $1,050,000. But they still need to pay back the yen they shorted at 1%, which would be $101 million yen, or $1,010,000 U.S. The difference between the two is $40,000 – the total profit of the trade and the exact 4% expected at the start of the trade.
While a currency carry trade can be a good strategy for investors, it comes with exceptional risks. In the earlier example, if the yen grew stronger, profits would lessen and that investor may actually lose money, depending on the yen’s growth rate.
For interested investors, a currency carry trade can be a great addition to a portfolio – so long as you take proper due diligence.