Carry Trade is a financial strategy in which investors borrow a low-interest rate currency (the currency from which funds are sourced) and convert it into a high-interest rate currency (the currency in which funds are invested) to earn interest differentials. Carry arbitrage is commonly used in the foreign exchange market.

​

​

Principles of carry trade

The core of carry trade is to take advantage of the interest rate differences between different countries or regions. Investors borrow currency with a low interest rate, then exchange it for currency with a higher interest rate and invest it. In this way, investors are able to earn higher returns from investing in high-interest-rate currencies, exceeding their cost of borrowing low-interest-rate currencies, thus earning a spread.

​

Steps to  carry trade

Borrow in a low-interest currency: Choose a low-interest currency to borrow, such as Japan's Japanese Yen (JPY) or Switzerland's Swiss Franc (CHF).

Convert to high-interest currency: Convert borrowed low-interest currency to high-interest currency, such as U.S. dollars (USD).

Invest in high-interest-rate currencies: Invest the converted high-interest-rate currencies, usually by depositing them into a high-interest-rate bank account or purchasing high-yield financial products, such as bonds or stocks, denominated in high-interest-rate currencies.

Obtain spread income: The income obtained from high-interest currency investment minus the cost of borrowing low-interest currency, and the remaining part is the investor's net income.

​

for example

Assume that interest rates in Japan are currently 0.1% and in Australia are 2.5%. An investor can conduct a carry carry trade by doing the following:

Borrowing Japanese yen: The investor borrows 100,000,000 yen from the Bank of Japan with an annual interest rate of 0.1%.

Convert to Australian dollars: Convert 100,000,000 Japanese yen to Australian dollars, assuming the current exchange rate is 1 AUD = 80 JPY, then investors can get 1,250,000 AUD.Invest in Australian dollars: Deposit AUD 1,250,000 into an Australian bank account with an annual interest rate of 2.5%.

Earning the spread income: After one year, the interest earned by the investor from the bank account in Australia is 1,250,000 AUD * 2.5% = 31,250 AUD. At the same time, the interest that investors need to repay the Japanese yen borrowed is 100,000,000 JPY * 0.1% = 100,000 JPY, which is approximately 1,250 AUD.

The investor's net income is 31,250 AUD - 1,250 AUD = 30,000 AUD. The portion after deducting exchange rate changes and transaction costs is the profit earned by the investor through interest arbitrage transactions.

​

risk factors

Although carry arbitrage trading seems simple, there are certain risks involved:

Exchange rate risk: Fluctuations in currency exchange rates may result in reduced actual returns or even losses from arbitrage transactions.

Interest rate change risk: If the interest rates of borrowed currency and investment currency change, arbitrage returns may be affected.

Market liquidity risk: Insufficient market liquidity may lead to increased exchange and transaction costs.

Macroeconomic risks: Changes in the global economic environment and policies may affect interest rate and exchange rate trends, thereby affecting the effectiveness of arbitrage transactions.

​

On July 25, the latest data from the United States showed that the U.S. economic growth was slowing down and market expectations for interest rate cuts were rising rapidly. There was also talk from Japan that it might consider raising interest rates at next week's interest rate meeting. The two pieces of news jointly promoted the interest rate hike in the United States and Japan. Poor expectations narrowed expectations.

​

What happens when spreads are expected to narrow?

The carry carry trade relies on borrowing in a currency with a low interest rate and investing in a currency with a high interest rate to earn interest rate differentials.

If interest rate spreads narrow, the attractiveness of carry trades will weaken, which may lead to capital outflows from high-interest-rate currencies and inflows into low-interest-rate currencies, thereby affecting exchange rates and market liquidity.

Faced with expectations of Japanese yen interest rate hikes and U.S. dollar interest rate cuts, arbitrageurs may begin to liquidate their positions early, withdraw funds from U.S. dollar assets and repay Japanese yen borrowings. This will lead to increased selling pressure on the U.S. dollar and a depreciation of the U.S. dollar; at the same time, increased demand for the Japanese yen will lead to an appreciation of the Japanese yen.

Investors will reassess the balance of risk and return, especially when arbitrage gains become less attractive. Some arbitrage funds may be diverted to other high-yield investment vehicles or markets.

Appreciation of the yen: arbitrageurs buy back large amounts of yen to repay their borrowings, causing the yen to appreciate. This appreciation trend may increase market confidence in the yen and further push up the yen exchange rate.

US dollar depreciation: The US dollar may face depreciation pressure as arbitrageurs sell US dollar assets and withdraw funds. This depreciation trend will further weaken the attractiveness of the US dollar as an arbitrage investment tool.

​

Driven by expectations of narrowing interest rate differentials between the United States and Japan and the return of funds, the Japanese yen carry trade reversed and the Japanese yen strengthened again.

On Thursday, July 25, the US dollar against the yen once fell below the 152 mark during the day, reaching the highest level in more than two months, with an intraday decline of more than 1%.

The International Monetary Fund (IMF) has issued a report studying the relationship between yen carry trade and the subprime mortgage crisis.

The report pointed out that the unwinding of the yen arbitrage trade often leads to the withdrawal of funds, triggering a global decline in asset prices, and will lead to a credit crunch as financial institutions deleverage.