Carry trade
1. Foreign currency - trading - speculation - naked positions.
In foreign currency trading, a naked carry trade - where the foreign currency trader has no other related offsetting contract, asset or liability - is a speculative strategy.
Like all speculative trades, it depends - for a favourable result - on prevailing market rates and prices turning out at the levels expected, or hoped for.
For non-speculative corporate hedging contexts and applications, see part 3 below.
A foreign exchange carry trade 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 favourable interest differential is known often known as the "carry".
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, which predicts that higher interest rate currencies depreciate - on average - by amounts equal to the interest rate differentials.
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 foreign exchange 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.
Carry trades are also known as a currency carry trades.
- 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. Trading - speculation - other financial assets.
Similar speculative trading 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 in respect of interest rates for different maturities of funds.
3. Treasury - cash management - risk management - foreign exchange risk - interest rate risk - funding diversification.
In a treasury cash management and risk management context, a similar trade undertaken as part of an overarching cash management or risk management strategy.
- Natural hedges and prudent approaches
- "Considering carry trades where there is an underlying exposure is a prudent approach for corporates.
- It helps in creating natural hedges, mitigating currency risk, enhancing cash flow matching and aligning with strategic goals.
- By focusing on these areas, companies can leverage carry trades to support their financial objectives as part of a holistic risk management approach while minimising the associated risks.
- This strategic alignment ensures that carry trades are not merely speculative punts but integral components of a comprehensive risk management and financial strategy."
- Understanding Carry Trades and How They Can Be Used: A Guide for CFOs and Treasurers - Lisa Dukes - Dukes & King -Treasury Management - August 2024.
See also
- Arbitrage
- Carry
- Chief Financial Officer (CFO)
- Cost of carry
- Covered interest arbitrage
- Day trading
- Depreciation
- Diversification
- Emerging currency
- Exotic currencies
- Expectations theory
- Financial asset
- Fisher Effect
- Foreign currency
- Foreign exchange risk
- Forward contract
- Funding
- Futures contract
- FX instrument
- Hard currency
- Hedging
- Interest arbitrage
- Interest rate parity
- Interest rate risk
- International Fisher Effect
- Natural hedge
- No arbitrage conditions
- Prudence
- Purchasing power parity
- Riding the yield curve
- Risk management
- Speculation
- Straddle
- Trader
- Treasury
- Uncovered
- Uncovered arbitrage
- Underlying
