What it means
The mechanics are simple to describe. Borrow where money is cheap, convert the proceeds, deposit or invest where money pays more, and keep the interest rate gap for as long as the exchange rate cooperates.
The return has two parts and only one of them is predictable. The interest differential, known as the carry, is fixed at the outset, while the currency move over the life of the trade is entirely uncertain and can dwarf the carry in either direction.
In theory the differential should be cancelled out by the high-rate currency weakening, which is what interest rate parity predicts. In practice that adjustment often fails to arrive for years at a time, which is why the strategy persists and why it appeals to funds and to some corporate treasuries.
The risk profile is what people underestimate. Carry trades typically produce many small gains followed by an occasional very large loss, and because so many participants hold similar positions the unwinding tends to happen all at once when sentiment turns.
Businesses meet the same idea without ever calling it a trade. Borrowing in a low-rate foreign currency to fund domestic operations is a carry position in everything but name, and it should be sized against the damage a sharp move in that currency would cause.
In practice
Real-world examples.
Example
A macro hedge fund borrows in a low-yielding European currency and invests in higher-yielding emerging market bonds, earning a spread of about 6% a year for three years. A sudden reversal in sentiment then removes two years of those gains in a fortnight.
Example
A property developer takes a mortgage in a foreign currency because the rate is three percentage points lower than the domestic equivalent. Two years later the balance owed in local terms has risen 15% after a currency move, while the rental income funding it has not changed at all.
Example
A corporate treasurer is offered cheap funding in a low-rate currency for a purely domestic project and declines it. His reasoning is that the company has no revenue in that currency to service the debt if the rate moves against it.
Formula
Calculation
Carry trade result = Value of the investment at maturity - Cost in the reporting currency of repaying the borrowing
A fund borrows 10,000,000 Swiss francs for one year at 2%, so it will owe 10,000,000 x 1.02 = 10,200,000 francs at maturity. At a spot rate of 1.25 francs per dollar the borrowing converts into 10,000,000 / 1.25 = $8,000,000, which the fund places on dollar deposit at 5%, growing to $8,000,000 x 1.05 = $8,400,000. If the exchange rate is unchanged at maturity, repaying the loan costs 10,200,000 / 1.25 = $8,160,000, leaving a profit of $8,400,000 - $8,160,000 = $240,000. If instead the franc strengthens to 1.20 francs per dollar, repayment costs 10,200,000 / 1.20 = $8,500,000 and the trade shows a loss of $8,400,000 - $8,500,000 = -$100,000, which shows how a 4% currency move wipes out a 3% interest advantage.Case study
Seen in the real world.
Fenwick Harbour Capital is an illustrative and completely fictional investment firm used here to show the shape of carry trade returns. For four years it ran a portfolio funded in a low-rate currency and invested in higher-yielding deposits abroad, earning a steady spread of roughly 3.5% a year with very little apparent volatility.
Investors came to treat the fund as a near-substitute for cash. The monthly statements were almost uniformly positive, the falls in value were tiny, and the firm's marketing described the returns as low risk on the strength of the track record alone.
Then the funding currency rallied 12% in three weeks as global markets turned defensive. The portfolio lost more than three years of accumulated carry in under a month, and Fenwick's fictional experience became the standard example in the firm's later materials of why a long run of small gains is not the same thing as low risk.
Watch out
Common mistakes.
- Describing a carry trade as low risk because its month-to-month returns look calm, when the risk shows up rarely and all at once.
- Borrowing in a cheap foreign currency without any revenue in that currency to service the repayment.
- Comparing only the two interest rates and ignoring the forward rate, which already prices in much of the expected currency movement.
Questions
People also ask.
What makes a currency attractive to borrow in?
Low interest rates, deep and liquid markets, and a recent history of stability, which is exactly the combination that draws crowded positioning.
How much can a currency move undo?
A move of 4% or so can erase a full year of carry, which is why position sizing matters more than the size of the spread.
Is a carry trade the same as arbitrage?
No, because arbitrage locks in a certain result while a carry trade leaves the exchange rate risk deliberately open.
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