1. Speculation - foreign currency.
A carry trade is a speculative foreign exchange trading strategy.
It involves borrowing a low interest-rate currency, and investing in a higher interest-rate currency.
The potential benefit to the trader is the interest differential between the higher interest income receivable on their investment, and the lower interest expense payable on their borrowing.
The downside is the loss on the likely depreciation of the higher interest-rate currency invested in.
The expected currency depreciation is predicted by the International Fisher Effect.
The losses on the currency depreciation can exceed the interest rate gains by many times.
For this reason, it is a very high-risk form of speculation.
The trader hopes that they will be able to enjoy gains on the interest rate differential and then close out the trade, before any sharp weakening of the higher interest rate currency.
Also known as a currency carry trade.
- Example: Emerging market currency - carry trade
- A trader borrows a hard currency at an interest rate payable of 1% per annum.
- They invest in an emerging market currency to enjoy an interest rate receivable of 10% per annum.
- So long as there is no change in the exchange rate between the two currencies, the trader enjoys a gain of (approximately) 10% - 1% = 9% per annum, for as long as the carry trade is open. Usually measured in days.
- However, the International Fisher Effect predicts that the emerging market currency will weaken against the hard currency, resulting in an offsetting exchange loss for the trader (who is holding the - now weaker - emerging market currency). By an average amount that can be calculated from the interest rate differential.
- If that didn't happen, then everyone in the market would be making such trades and earning consistent profits. Which doesn't appear to be happening in practice.
2. Speculation - other financial assets.
Similar speculative activity, where the financial asset invested in can be any asset that produces a higher rate of income than the cost of borrowing.
For example, riding the yield curve.
- Cost of carry
- Day trading
- Emerging currency
- Exotic currencies
- Expectations theory
- Financial asset
- Fisher Effect
- Foreign currency
- FX instrument
- Hard currency
- Interest rate parity
- International Fisher Effect
- No arbitrage conditions
- Purchasing power parity
- Riding the yield curve
- Risk management