Using Carry Trades to Maximize Profit
This lesson will cover the following
- What are carry trades
- Why are they so commonly used
- Why does market risk sentiment matter
- Other factors that affect carry trades
Weve 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 the current article we will discuss carry trades more thoroughly and explain why they are one of the favorite 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 capitalize on the difference between the rates, which can lead to substantial return, 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 ignore short-term fluctuations in currency exchange rates. Moreover, using lower leverage will allow the trader to hold onto his position for longer and reduce the chance of getting dropped out of the market by a strong price movement.
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However, although interest rates are not changed that often to impose risk of losses on a daily basis, a significant factor you need to take into consideration are shifts in the exchange rate of the two currencies. If the higher-yielding currency appreciates against its counterpart, this would be in your favor and increase return. However, the opposite scenario will reduce profit and may even run the risk of incurring losses, depending on the size of the move.
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 are hedging the exchange rate exposure. This way they are protected from fluctuations in the currencys 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.
Let us assume that the New Zealand dollar offers a 3% interest rate, while the Japanese yen offers only 0.25%. In order to execute the carry trade, an investor will need to borrow and sell Japanese yen, while buying New Zealand dollars, i.e. he goes long NZD/JPY. This would earn him a profit of 2.75% (3% interest earned from NZD minus 0.25% interest paid for JPY). Assuming the exchange rate remains constant, adding ten times leverage would yield 27.5% return on the interest rate differential alone. Additional profit might be achieved, if the exchange rate shifts in our favor, i.e. NZD appreciates against the Japanese yen (capital appreciation).
Capital appreciation is often observed, because the inflow of capital in the higher-yielding country essentially increases demand for its currency and thus raises its value. Lets 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 capitalize on in New Zealand. As you withdraw your money, sell your yen in order to buy New Zealand dollars, and then buy a New Zealand deposit, you essentially conduct a carry trade, which earns you an extra 2.75% in return. As more and more people do the same, demand for NZD will increase and appreciate it, which in terms will benefit you (capital appreciation). Meanwhile, the Japanese yen will depreciate as capital flows out and demand for the greenback declines.
Investors always seek to maximize return, thus they will prefer to invest their capital in countries with higher interest rates. If a countrys economy is performing well, i.e. grows at a fast pace, has low unemployment and so on, it can afford offering a higher rate of return on investment. In contrast, countries with weak growth prospects and productivity will offer a much lower interest rate to its 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 just two countries with a large enough difference in investment return rates, but also a crowd behavior which supports your sentiment. When it comes to the acceptance of risk, there are generally two types of investors – those who would undertake higher risk, i.e. risk-prone people, and those who would prefer a more safe environment – risk-averse investors. For a carry trade to work, you will 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 offering higher interest rates, but also because these transactions carry the uncertainty of whether the economy will continue to perform well and will be able to pay the higher return. Thus, in order to maximize 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 the least doesnt depreciate, if there are additional factors at play.
Things go south
Conversely, the worst time for executing carry trades is in a risk-aversion environment. When the majority of traders are avoiding risk, they will seek safe haven and prefer to invest in currencies which offer less return but retain capital. This is exactly the opposite of executing a carry trade and will cause capital inflow 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, this would drive demand for the yen up and appreciate it, although it offers smaller return, while depreciating the New Zealand dollar. If you are still holding on to your carry trade where you went long NZD/JPY, your profit will be eroded and you might be even running the risk of incurring losses. This is why it is crucial to be able to timely determine the general publics risk acceptance and position accordingly.
Although not frequently, global risk environment can shift completely within very short periods of time, leaving investors who cant adjust fast enough with losing investments. An example for that can be the 7% rally of the Swiss franc against the US dollar over the next ten days after the September 11 attacks on the World Trade Center. Some financial institutions have developed their own gauges of investor sentiment but an investor can get a general overview of risk aversion levels by monitoring the difference between bonds of different credit ratings – the higher the spread is, the higher the risk aversion is.
Apart from major shifts in global risk sentiment, a carry trade might go wrong as the lower-yielding currency strengthens due to improving economic conditions. As economic growth outlook improves, a country might become able to pay higher return rates 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 also have a weak growth outlook, apart from current sluggish growth, in order to maximize profit.