Currency Carry Trade

Currency Carry Trade

A strategy where an investor borrows in a foreign country with lower interest rates than their home country and invests the funds in their domestic market, usually in fixed-income securities.

Notes:

It's like free money, right? Well, not quite. The big risk is the uncertainty of exchange rates. Remember, you've still got to pay back the money in a foreign currency. If your domestic currency falls in value relative to the currency you borrowed, then you run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless hedged appropriately.

An example of a "yen carry trade" is borrowing 1,000 yen from a Japanese bank, exchanging the funds into U.S. dollars and buying a bond for the equivalent amount. Assuming that the bond pays more than the amount you must pay the bank for borrowing the funds, and the exchange rate does not move adversely, you will earn a profit.

See also: Arbitrage, Bond, Currency, Exchange Rate, Fixed Income Security

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Currency Carry Trade

A carry trade where you borrow and pay interest in order to buy something else that has higher interest. For currencies, it might be that you borrow in Yen (where the interest rate might be low) and use the proceeds to purchase U.S. dollar long term debt. While the trade might produce a positive return, it is risky in two dimensions. First, U.S. rates could increase diminishing the value of the bond you purchased. Second, the exchange rate could take an unfavorable move effectively increasing your borrowing costs. Related: Carry Trade.