(Bloomberg) -- Here’s what sounds like a surefire way to improve an asset’s returns: Use cheaper money to buy it. That’s the core of what’s known as a foreign-currency carry trade. Investors take advantage of a difference in interest rates between two countries to borrow where the rate is low and invest where it’s high. Carry trades are especially popular when central banks in different parts of the world pursue diverging monetary policies, as one country might fight inflation while another seeks to boost growth. But be warned. The trades can also be a good way to lose large sums, given that exchange rates are prone to unpredictable corrections. That’s what happened as the yen began appreciating sharply in July, wreaking havoc across global markets.
1. Why is it called a carry trade?
In finance speak, the “carry” of an asset is the return obtained from holding it. So a carry trade involves buying a currency and “carrying” it until you make a profit.
2. How does it work?
According to economic theory, the strategy shouldn’t work at all. High interest rates should imply that a country has poor economic fundamentals or faster inflation, and therefore its currency should depreciate. So the difference in interest rates between two countries should reflect the rate at which investors expect the high-interest-rate currency to depreciate against the low-interest-rate currency.
3. So why does it work?
In practice, yield-hungry investors are usually prepared to overlook poor fundamentals if the reward is high enough. The carry traders themselves then help to strengthen the high-interest-rate currency by investing in it. When that starts to happen, more investors want to get involved in the trade, helping the currency advance even more. The theory doesn’t always match reality. Sometimes, high interest rates come at a turning point when policymakers start to fix their economy, prompting appreciation in the country’s assets.
4. Why is the yen so important?
Until the 1990s, carry trades were the realm of hedge-fund managers betting on obscure emerging-market currencies, and the term was little known in mainstream finance. Then the Bank of Japan cut its interest rates close to zero and traders across the world realized they could make a profit borrowing in yen to buy dollar-based assets. That blew up in 1998 when the Japanese currency rose 16% versus the dollar in just one week, reversing years of profitability for carry-trade investors. The trade took another hit when the yen surged in 2007 against the dollar after the onset of the sub-prime mortgage crisis.
5. So is history repeating itself?
Maybe. Carry trades funded by the yen became popular again in the last decade as volatility remained low and traders bet Japanese interest rates would remain at rock bottom. Then the Bank of Japan raised interest rates for the first time in 17 years in March and hiked again in August. The second move, combined with hawkish rhetoric from the Bank of Japan and fears of a US slowdown, set off a surge in volatility in the currency. The subsequent rush to close out short yen positions jolted emerging and developed markets that had been destinations for investors deploying the strategy for higher returns.
6. How much money is at stake?
It’s hard to say. Carry trades are conducted via currency transactions that aren’t easy to track. One way of getting a rough estimate is by looking at contracts compiled by the Commodity Futures Trading Commission. That data shows hedge funds and other non-commercial investors were holding around 184,000 futures contracts betting on a weaker yen at the start of July. Those were worth more than $14 billion in notional terms, according to the CFTC data, although in reality the trade is probably much bigger. The latest data last week showed those positions have been cut to around $6 billion.
7. Are carry trades always vulnerable?
No. But when they are, it can be big trouble. Economists have likened the carry trade to picking up pennies in front of a steam roller — the money’s there for the taking, so long as you don’t dally and get crushed. Just ask US hedge fund FX Concepts, which went bust in 2013 when it reacted slowly to decisions by central banks across the world to cut interest rates to virtually zero. Reversals of fortune in carry trades can be triggered by a tightening of monetary policy in the low-interest-rate currency, an unforeseen event that reduces the attractiveness of the target currency or simply a realization in the market that the target currency has become detached from economic fundamentals.
8. What are some other examples of carry trades?
Investors have employed the trade for decades to make money betting on currencies including the South African rand, Hungarian forint and the Mexican peso. In 2018, Turkey and Argentina emerged as carry trade venues because of their central banks’ responses to their localized economic troubles. In 2022, traders saw an opportunity when a number of central banks in Latin America raised interest rates sharply in response to the inflation that followed the economic rebound from pandemic shutdowns, even as the US Federal Reserve and the European Central Bank left rates extremely low. And in 2024, thwarted expectations for aggressive rate cuts by the Fed reignited bets on the dollar, using the yen as a funding currency.
9. Who makes these trades?
These days the strategy is the territory of investors in bonds and other fixed-income assets and trades are typically short-term, according to the Bank for International Settlements.
10. How do they do it?
The most common way to implement a carry trade is to borrow money in Country A, where interest rates are low, exchange it for the currency of Country B, where rates are high, and invest in bonds in Country B. Investors who don’t want or aren’t able to invest in local-currency bonds can access carry returns through currency swaps and futures contracts, instruments that give payouts based on exchange-rate moves over time.
11. What are the returns like?
After adjusting for risk, some research suggests that the carry trade typically outperforms stocks. The Bloomberg Cumulative FX Carry Trade Index, which tracks the performance of eight emerging-market currencies versus the dollar, has had positive returns in 11 of the past 20 years — so gains by that measure are slightly more likely than a coin-flip.
--With assistance from Anya Andrianova.
©2024 Bloomberg L.P.
