Carry trade: what it means and why it’s a risky strategy

Traders tend to use their own money to invest and then buy and sell in the markets. However, some traders use loans for this instead, exploiting them with the aim of generating higher investment returns than the interest due.

This process is called carry trade, and it’s a type of investment strategy that is quite popular today. It does have advantages, but it also involves considerable risk factors that you need to understand before attempting to use it.

Let's take a closer look at what carry trading is and how it works to understand how risky this strategy can be.

Carry trade involves taking a loan with a low-interest rate and using this to make investments with a higher return. By doing this it’s possible to repay the loan while still making a profit from the higher return offered by the asset.

Often a carry trade involves converting a borrowed amount into another currency. A loan is taken out in a currency that offers a low-interest rate, and the sum is exchanged into a currency offering a higher rate. The borrowed capital can be deposited in the currency with the higher interest rate or used to buy stocks, bonds or commodities in the second currency.

In many cases, traders take advantage of the spread between the interest rates of different currencies. For example, a trader might borrow a currency such as GBP (sterling) and use it to buy JPY (Japanese yen). With a low-interest rate paid on the GBP loan, the trader might collect higher interest on JPY, making a profit equal to the spread between the two interest rates.

Carry trading is a highly risky activity, although it can also potentially be very profitable. The main advantage of the strategy is the possibility of increasing trading profits, as in addition to your profits from trading you can also profit from converting one currency to another.

However, exchange rates are very unstable and difficult to predict, and it’s this that makes the carry trade a high risk one.

That’s why it should only represent a small part of your trading activity; you must be aware of the risks and willing to accept a high level of risk. You must also monitor market sentiment carefully, closing your position immediately in the event of increased volatility, as even a small movement in exchange rates could cause considerable losses.

In general, carry trade is a popular activity among traders with a high risk appetite, especially during periods of stability or economic growth. Carry trading is not suitable for traders with a low risk tolerance, or during times of high uncertainty and market instability, as financial conditions may change quickly and cause large losses.

The most common carry trade strategy is making deposits in a different currency from the borrowed money. Basically, you borrow in a currency with a low-interest rate, convert the amount into a second currency and invest in a deposit that offers a good return. If the exchange rate remains the same at the end of the deposit, you get the full return. In contrast, if the currency of the deposit appreciates or loses its value you make an additional gain or loss.

Here's an example to aid understanding. Let's imagine you take out a loan of £10,000 from a UK broker paying a 1% commission. This money can be converted into an exotic currency, such as the Brazilian real, because a fixed deposit in this currency yields an annual interest of 5%. With an unchanged rate, it’s possible to make a 4% profit at the end of the year, however the exchange rate between the pound and the Brazilian real could fluctuate.

If the Brazilian real appreciates against the pound by 10%, your profit rises to 14%; the sum of the 4% profit on the deposit and the 10% currency appreciation. But if, the Brazilian real falls by 6% against the pound, the entire yield on the deposit is cancelled. And the currency's fall could be more pronounced, for example losing 10% against sterling and causing a 6% loss.

The same applies if you use the loan to invest in other financial products, especially assets with a more volatile price, such as shares and commodities. In these cases, the uncertainty linked to exchange rates would be compounded by the volatility of the price of these assets, an aspect that, while increasing the trader's potential profits, also increases the risks.