Using carry trades to maximise profit
This lesson will cover the following
- What carry trades are
- Why they are so commonly used
- Why market risk sentiment matters
- Other factors that affect carry trades
We’ve mentioned carry trades on several occasions previously in our trading guide, including in the article “Profile of the Swiss Franc – Characteristics and Major Economic Indicators“, but we only scratched the surface. In this article, we will discuss carry trades more thoroughly and explain why they are one of the favourite trading strategies of investment banks and hedge funds.
In a carry trade, an investor sells one currency with a relatively low interest rate and uses the funds to purchase a higher-yielding currency. The goal is to capitalise on the difference between the rates, which can lead to substantial returns, especially when using high leverage. This is a long-term investment strategy to which an investor should be ready to commit for at least six months in order to ride out short-term fluctuations in currency exchange rates. Moreover, using lower leverage will allow the trader to hold on to their position for longer and reduce the chance of being forced out of the market by a strong price movement.
However, although interest rates are not changed often enough to pose a risk of daily losses, you need to take into consideration significant shifts in the exchange rate between the two currencies. If the higher-yielding currency appreciates against its counterpart, this would be in your favour and increase returns. However, the opposite scenario will reduce profit and may even carry the risk of losses, depending on the size of the move.
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As you factor in leverage, a relatively small movement in exchange rates can turn the carry trade into a losing position, which is why some traders hedge their exchange rate exposure. This way they are protected from fluctuations in the currency’s value and rely solely on the interest-rate differential to profit. Although it tends to be rather small, usually between 1% and 5%, adding leverage can still yield substantial profits.
Example
Let us assume that the New Zealand dollar offers a 3% interest rate, while the Japanese yen offers only 0.25%. To execute the carry trade, an investor would need to borrow and sell Japanese yen while buying New Zealand dollars, i.e. they go long NZD/JPY. This would earn a profit of 2.75% (3% interest earned from NZD minus 0.25% interest paid for JPY). Assuming the exchange rate remains constant, applying ten-times leverage would yield a 27.5% return on the interest-rate differential alone. Additional profit might be achieved if the exchange rate moves in our favour, i.e. NZD appreciates against the Japanese yen (capital appreciation).
Capital appreciation is often observed because the inflow of capital into the higher-yielding country essentially increases demand for its currency and thus raises its value. Let’s assume that you have a deposit in a Japanese bank, which earns you 0.25% return, as opposed to the 3% interest rate you could earn in New Zealand. As you withdraw your money, sell your yen in order to buy New Zealand dollars and then place a deposit in New Zealand, you essentially conduct a carry trade, which earns you an extra 2.75%. As more and more people do the same, demand for NZD will increase and appreciate it, which in turn will benefit you (capital appreciation). Meanwhile, the Japanese yen will depreciate as capital flows out and demand for it declines.
Investors always seek to maximise return; thus, they prefer to invest their capital in countries with higher interest rates. If a country’s economy is performing well – growing at a fast pace, showing low unemployment, and so on – it can afford to offer a higher rate of return on investment. In contrast, countries with weak growth prospects and productivity will offer a much lower interest rate to investors. Having these two different types of economies is what makes carry trades possible.
Strength in numbers
For carry trades to work, however, you need not only two countries with a large enough difference in investment returns but also crowd behaviour that supports your sentiment. When it comes to risk appetite, there are generally two types of investors – those who are willing to undertake higher risk, i.e. risk-prone people, and those who prefer a safer environment – risk-averse investors. For a carry trade to work, you need the general public to be risk-prone, and here is why.
Carry trades are based on risk. Higher-yielding currencies offer a better return not only because the country is more productive and can afford to offer higher interest rates, but also because these transactions carry the uncertainty of whether the economy will continue to perform well and be able to pay the higher return. Thus, in order to maximise profit, investors as a whole need to be risk-prone so that capital flows from the lower-yielding into the higher-yielding country and the currency you are buying appreciates against its counterpart, or at least does not depreciate if other factors are at play.
Things go south
Conversely, the worst time for executing carry trades is during periods of risk aversion. When the majority of traders are avoiding risk, they will seek a safe haven and prefer to invest in currencies that offer lower returns but preserve capital. This is exactly the opposite of executing a carry trade and will cause capital to flow into the lower-yielding economy from the higher-yielding economy.
In our case, as investors become risk-averse and want to keep their investments safe instead of seeking higher risk and return, they would sell their NZD deposits and buy back JPY deposits. As thousands or even millions of investors do the same, demand for the yen would rise and it would appreciate, although it offers a smaller return, while the New Zealand dollar would depreciate. If you are still holding your carry trade where you went long NZD/JPY, your profit will be eroded and you might even run the risk of incurring losses. This is why it is crucial to be able to determine the general public’s risk acceptance in a timely manner and position accordingly.
Although infrequent, the global risk environment can shift completely within very short periods, leaving investors who cannot adjust fast enough with losing positions. For example, the Swiss franc rallied 7% against the US dollar during the ten days following the 11 September attacks on the World Trade Center. Some financial institutions have developed their own gauges of investor sentiment, but an investor can gain a general overview of risk-aversion levels by monitoring the spread between bonds of different credit ratings – the wider the spread, the higher the risk aversion.
Apart from major shifts in global risk sentiment, a carry trade might go wrong if the lower-yielding currency strengthens due to improving economic conditions. As the economic growth outlook improves, a country might become able to pay higher rates of return on investments, which will induce demand for its currency and reverse capital flows. Logically, this would devalue the previously higher-yielding currency and cause losses to investors holding on to their carry trades. Thus, it is important for the lower-yielding country to have not only sluggish current growth but also a weak growth outlook in order to maximise profit.