Resource Center : Carry Trade

The FX carry trade essentially involves taking advantage of low borrowing costs in one country (Japan for instance) and high fixed income investment rates in another country (New Zealand and Australia for instance). You get paid to 'carry' the trade over time. Traders use this strategy to capture the difference between the prevailing interest rates in the respective countries.

At the end of the forward term, if the spot rate has moved up you will have an FX gain to add to your carry gain. But if the spot rate moves down, as it has in dramatic fashion recently, the FX loss will cut into your carry gain and may even wipe it out.

Example:

Here's an example of a "yen carry trade": a trader borrows 1,000 yen from a Japanese bank, converts the funds into U.S. dollars and buys a stock for the equivalent amount. Let's assume that the stock pays a dividend of 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% (4.5% - 0%), as long as the exchange rate between the countries does not change. Many professional traders and hedge funds use this trade because the profits become very large when the trade is highly leveraged. If the trader in our example uses a common leverage factor of 10:1, then they can stand to make a profit of 45%.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar was to fall in value (by more than 4.5%) relative to the Japanese yen, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless hedged appropriately.