What is Carry Trade?

Suppose that the deposit interest rate in Europe stands at -0.25% and the interest rate in the USA stands at 1.0%. Let’s also assume that the EURUSD rate is at 1.10 and that we do not expect it to move in the next year. Investors, aware of this situation would be willing to borrow from Europe and deposit in the US, benefiting from the interest rate differential.  By doing so our trader would end up making 1.25% somewhat risk-free return. This investment, where the money is “carried” to another location (physically until the mid-20th century), is called the Carry Trade.

While the carry trade appears to be very simple, many dangers lie in its application. Remember that our second and most crucial assumption was that the exchange rate would not move. Nonetheless, the exchange rate seldom remains stable. In fact, the inflow of capital – deposits in our example – is what actually makes the exchange rate move. This is why, in an earlier post, we have already specified that a change in interest rates can be suggestive of the future movement of the exchange rate. This is indeed why EURUSD has been under pressure for so long! Investors have been taking advantage of the lower interest rates in Europe and holding onto stronger USD.

Carry trade example

Let's look more into our EURUSD carry trade example. In order for the trade to be successful, the EURUSD rate must not depreciate to an extent after which profits will be eaten out. Suppose that our investor wishes to borrow EUR1 mln and carry it into the USD. Thus, he would be depositing USD1.1 mln in the US with the hope of getting back USD 1.11375 mln one year from now. If the exchange rate remains at 1.10 then the investor would transform the money to EUR1.0125, repay the loan, and enjoy a EUR12,500 profit. Nonetheless, if the exchange rate moves to 1.11 then the investor’s profit is reduced to just EUR 2,500 after the loan is repaid. As you can imagine, the Dollar profit turns into a Euro loss if the exchange rate moves to 1.12. As you may have guessed, in order for the trade to be profitable, the exchange rate should not move by more than the exchange rate differential, which is not what the Inverse Fisher effect suggests.

As such, for the carry trade to be successful, there needs to be substantial room for error. Thus, there must be a large interest rate differential. Furthermore, traders need to find a currency pair in which the currency with the highest interest rate is not expected to depreciate too much.

How to identify Carry Trade opportunities?

Can you actually find carry trade opportunities so easily? Of course not. However, it is possible. In 2016, the Russian interest rate stood at 11%, while the respective interest rate in the US stood at 0.5% and remained at that point. This would imply an interest rate differential of approximately 10.5% for the year. The USDRUB exchange rate stood at 72.91 on January 4, 2016 and ended up at 60.68 on December 29, 2016. Suppose now that an investor borrowed USD 1 mln, exchanged it for RUB 72.91 mln, and invested it in Russia. By the end of the year, the investor would have gained 11% on his RUB investment, at a value of RUB 80.93 mln. Exchanging it back to USD at the 60.68 rates would mean that the trade would have ended with a value of USD 1.334 mln, which after deducting the USD 1.005 mln, would leave the trader with approximately USD 330,000, or a 33% return on the investment.

Hence, while carry trade opportunities are rare, they can be present if you make good and careful research. However, one should remember that carry trades are high-risk strategies. You must always follow a strong risk management strategy.