Many investors have never heard of the term carry trading. However, when this forex investment strategy affects the stock market, it’s suddenly in everyone’s Google search bar. What is carry trading exactly?
It involves borrowing funds in a currency with a low interest rate and investing those funds in an asset or currency with a higher interest rate. The primary goal is to capture the difference between the interest rates, known as the interest rate differential. Here is everything you need to know about carry trading and how it can affect stock markets globally.
Table of Contents
Carry Trading and the Japanese Yen
The Japanese Yen (JPY) has maintained very low interest rates, hovering around 0% for years. Many borrowed it almost interest-free and converted it into a currency with a higher interest rate, such as the Australian Dollar (AUD) or the New Zealand Dollar (NZD). The interest rate on the Yen was even negative for many years to boost the economy, but that didn’t go as expected for many reasons.
In August 2024, the interest rate to borrow the Yen was raised from 0% and 0.10% to 0.25% (the highest level in 15 years!), and the markets went wild. Japan’s main stock market index, the NIKKEI, lost over 12% in a single trading session.
At one point, it was down nearly 25% in a single month. In the US, many believed Black Monday would repeat itself at the opening bell on Monday, August 5th, due to this interest change. Thankfully, the day was bloody, but most stocks recovered later in the week.
Carry Trading Example
Before we explore carry trading any further, let’s look at an example to understand this strategy better.
- A trader borrows 1,000,000 JPY at an interest rate of 0.1%.
- The trader converts the 1,000,000 JPY into NZD, which has an interest rate of 6%.
- The funds are invested in NZD in a high-yielding asset or deposit.
- In 12 months, the trader earns 6% on the NZD investment while paying only 0.1% on the JPY loan.
Profit: The trader earns the interest rate differential of 5.9% minus any transaction costs or fees. That’s a very reasonable profit for the amount of effort invested. Unfortunately, it doesn’t always work out this way for everyone.
That’s not all. Carry trading is also very popular, thanks to leverage. It can amplify the return (and risks). If the trader has a 10:1 leverage, the amount borrowed and the potential return are multiplied by 10.
Carry Trading Risks
For some, carry trading is and has been very profitable. Unfortunately, that’s not always the case, especially for those involved in leverage carry trading. Here are the risks involved with this strategy.
1. Exchange Rate Risk
The primary risk in carry trading is exchange rate fluctuations. If the currency borrowed appreciates significantly against the currency invested, the trader could face substantial losses.
For example, if the JPY strengthens against the NZD, the trader will need more NZD to repay the JPY loan. As a result, this can potentially wipe out any interest rate gains.
Conversely, if the NZD becomes stronger, the returns amplify. We will look at a few examples in the section below.
2. Interest Rate Risk
Changes in interest rates can also impact carry trades. If the central bank of the borrowed currency raises interest rates, the cost of borrowing increases, reducing the profitability of the trade. This is exactly what happened in Japan.
On the other hand, if the central bank of the invested currency increases interest rates, the returns increase. When central banks consider raising their interest rates, it tends to be the best time to get into carry trading. Trading a currency pair can increase its value if more people are trading it.
3. Market Volatility
What is the best environment for trading and investing? Low volatility. High market volatility can lead to rapid unwinding of carry trades, causing significant currency movements and potential losses.
This year, the markets have been relatively volatile. As a result, this has caused many investors, including Warren Buffet, to sell a portion of their risky portfolio and replace it with safer assets.
4. Liquidity Risk
In times of financial stress, liquidity can dry up. This makes it difficult to maintain or exit carry trades without incurring losses.
5. Leverage
We conclude this section with leveraging. Carry trading often involves leverage, meaning traders borrow more than their initial capital to increase returns.
While leverage can increase profits, it also magnifies losses. A small adverse movement in the exchange rate can lead to substantial losses if the position is highly leveraged.
Historical Examples of Carry Trades
There exist several examples of carry trading with various currencies. Below is one example of the Turkish Lira and two examples of the Japanese Yen.
The Japanese Yen Carry Trade (2000s)
During the 2000s, Japan maintained ultra-low interest rates, while many other countries had higher rates. Traders borrowed in Yen and invested in higher-yielding currencies like the AUD (interest rate surpassed 7% in 2008), NZD (interest rate reached 8.25% in 2007), or emerging market currencies.
The Yen carry trade was so popular that it became a significant driver of global financial markets.
However, the 2008 global financial crisis led to a sharp unwinding of carry trades. As investors fled to safer assets, the Yen appreciated sharply while other currencies depreciated. It caused massive losses for those holding Yen carry trades.
The Turkish Lira Carry Trade (2010s)
In the early 2010s, Turkey offered very high interest rates compared to developed economies. The Turkish Lira became a popular target for carry traders.
Unfortunately, political instability, economic mismanagement, and external pressures led to a sharp depreciation of the Lira in the late 2010s. Traders engaged in carry trades involving the Lira faced severe losses as the currency’s value plummeted.
Since 2010, the Lira has lost almost 95% of its value against the USD and the Euro.
Japanese Yen Part 2 (2024 and Beyond)
The recent increase in Japan’s interest rates is expected to have several international effects on stock markets worldwide. Japanese investors who are significant holders of foreign assets may start repatriating their investments to Japan due to the higher domestic yields.
Next, a stronger Yen makes Japanese exports more expensive, which could impact companies and markets reliant on Japanese goods. Finally, the end of Japan’s low interest rates could reduce the attractiveness of yen-funded carry trades.
This is all hypothetical. The effects can be softer or more damaging. The Bank of Japan (BOJ) has indicated that it may continue to raise its interest rates depending on economic conditions. Japan’s evolving monetary policy and target inflation rates will play a big role in the future.
Modern-Day Carry Trading
Today, carry trading remains a decent strategy, but traders must be more cautious due to market volatility and geopolitical issues. Here are a few things to keep in mind.
Quantitative Easing and Low Interest Rates
Since the 2008 financial crisis, many central banks have adopted policies like QE, leading to historically low interest rates in many countries.
This has reduced the opportunities for carry trades, as the interest rate differentials are narrower. Of course, since the pandemic, interest rates have increased, but they will likely begin decreasing soon.
Emerging Markets
Some traders have turned to emerging market currencies for carry trades, where interest rates can be significantly higher. However, these markets have higher risks, including political instability, currency controls, and less predictable economic policies.
Some popular emerging markets are Brazil, Argentina, Russia, South Africa, Indonesia, India, Mexico, Nigeria and Egypt. Many have interest rates of around 10%, while some are over 40%.
Diversification
Many carry traders diversify their positions across multiple currency pairs to spread risk. By not putting all their eggs in one basket, they can reduce the impact of adverse movements in any single currency.
Hedging
Some traders use options or other financial instruments to hedge against potential adverse movements in exchange rates. While hedging can reduce profits, it also limits potential losses.
Final Thoughts: Carry Trading
To conclude, carry trading is a forex investment strategy aiming to borrow a currency with a low interest rate and exchange it for a higher-yielding currency. Some high-yielding currencies, such as the AUD or NZD, are relatively safe.
On the other hand, some countries like Brazil, South Africa, and Argentina offer attractive interest rates on their currencies, but their geopolitical conditions aren’t very enticing.
According to some analysts, carry trading has recently decreased by nearly 75% due to increased market volatility and decreasing interest rates (or increasing in Japan’s case). To what extent will it affect the global economy and stock markets?
If you want to learn more about profiting from the stock market, head to our free library of educational courses. We have something for everyone, including trading options for those with small accounts.
Frequently Asked Questions
Traders borrow money from a country with low interest rates and invest it in countries with higher interest rates.
A small movement in exchange rates can cause big losses (or profits), especially when leverage is involved.
As of August 2024, the interest rate is 0.25%.
