Currency Carry Trade
What is a ‘Currency Carry Trade’
A currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.
USD/JPY (U.S. Dollar/Japanese Yen) .
BREAKING DOWN ‘Currency Carry Trade’
The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, the trader runs 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 the position is hedged appropriately.
Currency Carry Trade Calculations Example
As an example of a currency carry trade, assume that a trader notices that rates in Japan are 0.5% while in the United States they are 4%. This means the trader expects to profit 3.5%, which is the difference between the two rates. The first step is to borrow yen and convert it into dollars. The second step is to invest those dollars into a security paying the U.S. rate. Assume the current exchange rate is 115 yen per dollar and the trader borrows 50 million yen. Once converted, the amount that he would have is:
U.S. dollars = 50 million yen / 115 = $434,782.61
After a year invested at the 4% U.S. rate, the trader has:
Ending balance = $434,782.61 x (1 + 4%) = $452,173.91
Now, the trader owes the 50 million yen principal plus 0.5% interest for a total of:
Amount owed = 50 million yen + (50 million yen x (1 + 0.5%)) = 50.25 million yen
If the exchange rate stays the same over the course of the year and ends at 115, the amount owed in U.S. dollars is:
Amount owed = 50.25 million yen / 115 = $436,956.52
The trader profits on the difference between the ending U.S. dollar balance and the amount owed which is:
Profit = $452,173.91 — $436,956.52 = $15,217.39
Notice that this profit is exactly the expected amount: $15,217.39 / $434,782.62 = 3.5%
If the exchange rate moves against the yen, the trader would profit more. If the yen gets stronger, the trader will earn less than 3.5% or may even experience a loss.