The carry trade is a well-known currency trading strategy that has gained huge popularity among investors and traders in recent years. In a carry trade, an investor borrows money in a low-rate currency, such as the Japanese yen, and then invests it in assets in a higher-rate currency. The idea is to profit from the interest rate differential between the two currencies.
Traditional safe havens, such as the Japanese yen or the Swiss franc, rose sharply in value on Monday, fuelling speculation that some investors were trying to wind down profitable carry trades to cover their losses elsewhere. But what if we put on our academic hat? What is the opinion on this trade?
Figure 1: (A) the EW carry trade is an equal-weighted portfolio with 20 exchange rates against the Dollar. (B) the HML carry trade is when you weight by interest rates and (C) is the excess market return
There are several reasons why the carry trade is so popular among investors. In an environment of low interest rates, the carry trade can deliver very attractive returns. The strategy is relatively simple to understand and execute. Moreover, it is self-reinforcing: if many investors enter into carry trades, this reinforces the trend, which in turn attracts more investors. By borrowing, a large position can be taken with a relatively small deposit.
Figure 2: returns when you sort by interest rate level and interest rate differential
Despite its attractions, it also has significant risks:
- Currency risk is significant: if the currency in which is borrowed rises in value compared to the investment currency, this can wipe out profits (or even lead to losses).
- Changes in interest rate differentials between currencies can affect profitability.
- When markets are turbulent, it can be difficult to unwind positions quickly. If too many investors follow the same strategy, it can lead to sudden, large price movements.
We have also seen this this week. Japan’s Nikkei had its biggest fall since 1987.
In periods of market calm and low volatility, carry trades can be very profitable, but in times of uncertainty or crisis they can quickly go wrong. We saw this for instance during the 2008 financial crisis, during the 2020 corona crisis and also this week. At moments of panic in the financial markets, we often see a «flight to safety». Investors then withdraw their money en masse from risky investments and seek refuge in safe havens such as the Japanese yen or the Swiss franc. This leads to rapid appreciation of these «funding currencies», which can be disastrous for open carry trades.
Figure 3: VIX
However, recent research shows that carry trade profitability decreases as bond maturity increases (see Figure 4). While the strategy with short-term government bonds yields significant gains, these disappear with long-term bonds. This is because local currency bond premiums offset currency risk premiums.
Figure 4: carry trade when taking into account bond maturity.
Conclusion
The carry trade is a fascinating strategy that is attracting the attention of traders and academics alike. While the potential returns are attractive, investors should be aware of the significant risks, especially in times of market volatility.
For the average retail investor, the carry trade is probably too risky. However, professional traders with good risk management can still benefit from it, provided they recognise the dangers and manage their positions carefully. It remains an area of active research, with new insights continuing to deepen our understanding of foreign exchange markets and international finance.
Gertjan Verdickt is assistant professor of Finance at KU Leuven and a columnist at Investment Officer.