Carry trade is borrowing or selling financial instruments that incur a small interest rate and then buy another financial instrument that incurs a bigger interest rate. Hence, you are paying a small interest rate for the financial instrument you borrowed or sold and simultaneously receiving money from the financial instrument you bought with a more significant interest rate. You get profits from the difference between the small and bigger interest rates. If we think about it, this is a trade where you can see gains as long as the price remains constant in the long run.
Let us cite an example.
Lucia goes to the bank to borrow $5,000, and the lending fee is 1% of that amount per year. On the other hand, she also buys a $5,000 bond to pay her 6% of that amount per year. In that sense, she gets 5% of that amount per year since 6% – 1% is equal to 5%, which is the difference between both interest rates. You might think that it does not amount to much, but what if this amount is more considerable? You can sit and watch your money grow in the long run.
Carry trades and leverages
What if Lucia goes into the bank to borrow a comparably larger amount? Let us assume that Lucia wants to borrow $1 million with an interest of 1% of that amount. However, the bank will require Lucia to pay $10,000 collateral in cash from you. They will return this money to you when you pay back the money. The bank approves her loan! Later on, she deposits that money to another bank, giving her a 4% interest rate per year. So, how much is she going to get? Let’s see:
- Bond interest rate ($1,000,000* 0.04) = $40,000
- Lending fee payment ($1,000,000* 0.01) = $10,000
- What you got ($40,000 – $10,000) = $30,000
In only a year, you gained a $30,000 net profit. See how carry trades with leverages can bring so many profits. In this example, Lucia realized a 300% return.
Will they always work?
They will work if brave and optimistic investors buy currencies that yield high and sell currencies that yield low. The economy may not be looking well right now, but the investor must be confident about buying. If the economy is expected to be good, the central bank tends to have higher interest rates to control inflation. High-interest rates mean higher interest rate differential.
However, sometimes carry trades will not work. They will not work when the economy does not look all too good since nobody would want to buy that currency thinking that the central bank will have lower interest rates.
Ending the topic
Carry trades will most likely work when investors have low-risk aversion and vice versa. High-risk aversion means less courage from investors. For instance, a country’s economy is down because there is a recession. It is only natural for the neighboring countries to have a safer investment even if the interest would be low. The only important thing would be preserving the principal.