Currency carry trade refers to a strategy that is used by investors to sell currencies with low interest rates and purchase currencies with a high interest rate, in order to capture the difference that exists between the rates and leverage that is being used.
The strategy is used by investors that work for big institutes. The main purpose of the currency carry trade is to get profit because of the differences that exist in the interest rates of different currencies.
Learning about Currency Carry Trade
One good thing about currency carry trade is that the investment does not need to double in value in order to give profit to investors. The investors simply have to carry the investment as that will give them profit because of the disparity of rates.
Success of Currency Carry Trade
To be successful with currency carry trade is to see the direction of the spread of currency. If you want success in currency carry trade, opt for a currency expanding against a currency that has a low interest rate and is stationary.
When Currency Carry Trade Works
There are two situations in which the currency carries trade works:
Increased Interest Rates by the Central Bank
The currency carry trade works efficiently when the central bank changes the interest rates because that means investors can easily move around their money in search of a higher yield and capital appreciation. What happens is that when the central bank changes the interest rate of a currency, everyone who has invested in it takes notice that gives the value of the currency an upward surge.
Low Volatility
Carry trades tend to perform well in environments that are not volatile because investors are ready to take the risk. So even if the currency does not get a surge, investors do well because of the leveraged yield.
When Currency Carry Trade Does Not Work
The situations in which the currency carry trade does not work are:
When the Interest Rate Is Reduced
When the interest rate is reduced, it affects the profitability. When there is a reduction in the interest rate, foreign investors tend to focus more on other currencies, which affects the demand of the currency in question. The end result is that the exchange rate loses its value by more than just the average annual yield.
When the Central Bank Intervenes With the Currency
Intervention of central bank, in order to prevent its currency from falling any further, also causes the currency carry trade to fail.
Further Reading
- Currency carry trade regimes: Beyond the Fama regression – www.sciencedirect.com [PDF]
- Carry trade and momentum in currency markets – www.annualreviews.org [PDF]
- Evidence of carry trade activity – papers.ssrn.com [PDF]
- The term structure of currency carry trade risk premia – www.aeaweb.org [PDF]
- Beyond the carry trade: Optimal currency portfolios – www.cambridge.org [PDF]
- Getting beyond carry trade: What makes a safe haven currency? – www.sciencedirect.com [PDF]
- The time-varying systematic risk of carry trade strategies – www.jstor.org [PDF]
- Do peso problems explain the returns to the carry trade? – academic.oup.com [PDF]
- Leveraged carry trade portfolios – www.sciencedirect.com [PDF]
