What is Carry Trade?

What is Carry Trade?

It is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. By using this strategy, a trader basically attempts to capture the difference between the prevailing interest rates, which can often be substantial, depending on the amount of leverage used.

Example:

A trader borrows 1,000 Japanese yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that the bond pays 2% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 2% as long as the exchange rate between the countries does not change.

History of Carry Trade

Looking at the history, Carry Trade first started in Japanese Yen in 1995 which lasted till 1998, and a period of 2000- 01 and 2004-07 also saw the phase of the Yen Carry Trade. Interest rates, which determine the Carry Trade started inching down since 1991 and fell below 1%. Taking this as an opportunity the investors started using Yen as a funding currency for various forms of speculation around the rest of the world. Japan was the first nation to start monetary easing aggressively and therefore carry trade started in Yen.

By the summer of 1998, the borrowing in Yen was so huge that it made the USD/JPY to move towards 146 levels. The yen weakened more than 80% against the dollar from its peak of 80.43 three years before.

Since 2008, the carry trade shifted to US as they cut down the interest rates to 0.25% and also due to Fed’s Quantitative Easing program.

Unwinding of carry trade

The significance of Carry trade is that it unwinds brutally fast, and impacts all financial markets. Whenever carry trade unwinds, it leads to dramatic appreciation in the currency. For example, during Aug-Oct 1998, when Yen carry trade unwound, yen appreciated by whopping 25% in just 3 months.