A carry trade is an investment strategy that is often utilized in currency trading. Sometimes referred to as a currency carry trade, the process involves selling currency that has a low rate of interest and using the proceeds from the sale to secure a different currency that carries a higher interest rate. The idea behind carry trades is to earn a return from the difference in the rates.
Carry trades make it possible to earn returns based on the difference in the interest rate between the two transactions. To execute a trade, an investor may borrow funds from a bank in one nation, then convert those funds into a different currency. The currency is then used to secure a bond issue that carries a higher rate of interest than the interest rate on the loan. Assuming that the loan can be paid off before there is any significant fluctuation in the exchange rate between the two currencies involved, the return on the carry trading can be significant.
In order for carry trades to be successful, close attention must be paid to the exchange rates of the two currencies involved. Ideally, the goal is to sell and buy currencies that tend to remain somewhat stable in their relation to one another. At the same time, there is a need to assess current market conditions and determine if there are any signs that upcoming events will have a detrimental effect on either of the currencies involved in the trade. Investors also take note of events such as general shifts in the economy, political events, or even acts of nature that may impact the performance of the two currencies.
There is some degree of risk involved with carry trades. Should the currency used to acquire a bond begin to decrease in value in comparison to the currency that was obtained from the loan, the return will be decreased. Should the decrease continue, there is also a chance that the investor would eventually incur a loss. Building a certain amount of leverage into the execution of the strategy can minimize the risk, but does not completely eliminate the opportunity for a loss to occur.
Since the exchange rates between currencies can shift quickly, monitoring the progress of carry trades is extremely important. Ideally, the series of transactions used in the trade can be adapted to changing circumstances and offset the effect of undesirable shifts in the exchange rates involved. Depending on the relative stability of the two currencies involved, the investor may have to spend considerable time monitoring the foreign exchange market in order to protect his or her investment.
