What Is a Carry Trade?
For the bond market, this refers to a trade where you borrow and pay interest to buy something else that has higher interest. For example, with a positively sloped term structure (short rates lower than long rates), one might borrow at low short-term rates and finance the purchase of long-term bonds. The carry return is the coupon on the bonds minus the interest costs of the short-term borrowing. Of course, if long-term interest rates unexpectedly rose(and long-term bond prices fell as a result), the carry trade could become unprofitable. Indeed, if this occurred, several investors could be trying to unwind the carry trade, which would involve selling the long-term bonds. It is possible that this could exacerbate the increase in long-term interest rates, i.e., push the rates even higher. For currency, you buy the money that has the highest local short-term interest rate.
The Risks of carrying Trades
Although carry trades can contain potential financial rewards, this strategy can also pose significant risks, including
- The risk of a sharp decline in the price of the invested assets
- The implicit exchange risk, or currency risk, when the funding currency differs from the borrower’s domestic currency
Currency risk in a carry trade is seldom hedged because hedging would impose an additional cost or negate the favorable interest rate differential if currency forwards—or contracts that lock in the exchange rate for a time in the future—are used.
How a Carry Trade Can Negatively Affect the Economy
For example, by 2007, the carry trade involving the Japanese yen had reached $1 trillion as the yen had become a favored currency for borrowing thanks to near-zero interest rates. But as the global economy deteriorated in the 2008 financial crisis, the collapse in virtually all asset prices led to the unwinding of the yen carry trade. In turn, the carry trade surged as much as 29% against the yen in 2008 and 19% percent against the U.S. dollar by 2009.