There is a type of trading strategy that can generate consistent returns even when prices across all currency pairs remain stable—in fact, it could even be said to guarantee profits. This is the carry trade, which is the focus of this article. However, what exactly is the carry trade, and is it really as safe as the market claims? By the end of this article, you’ll have a clear understanding of how the carry trade works.
Carry trade, also known as rollover trading, was originally designed to earn interest by shorting products in a low-interest-rate market while simultaneously going long on an equivalent amount of products in a high-interest-rate market.Let’s use a story to explain carry trade in simpler terms. In the 1990s, Japan decided to implement a monetary policy of near-zero interest rates for the long term. This meant that, in Japan, depositing money in a bank was essentially equivalent to receiving no interest, while in the United States at that time, deposit interest rates were extremely high—even exceeding 8% per year.At that time, Japanese women—who often held the reins of household finances—realized they could first exchange yen for dollars, deposit the dollars in a bank to earn interest on them, and then convert the dollars back to yen when they needed the money.As long as the yen-dollar exchange rate remained stable, they could effectively earn high interest returns on their yen. As more and more Japanese people discovered this method, a specific term emerged in the foreign exchange market to describe this group: “Mrs. Watanabe.”Some “Mrs. Watanabes,” however, were not content with trading only their own savings. They decided to borrow yen at extremely low interest rates, convert the borrowed yen into U.S. dollars, and deposit the dollars in a bank to earn returns. In this way, “Mrs. Watanabes” were able to achieve even higher returns.Coinciding with the yen’s ongoing depreciation at the time, “Mrs. Watanabes” discovered that even without factoring in interest, this exchange strategy could yield a decent profit. For example, if they initially exchanged 100 yen for U.S. dollars at an exchange rate of 100 yen to 1 dollar, and the yen subsequently depreciated,the exchange rate changed to 125 yen to 1 U.S. dollar. By exchanging the U.S. dollars back into yen, the 100 yen effectively became 125 yen. This behavior by Mrs. Watanabe is known as carry trade.
As can be seen from the example above, there are two ways to profit from carry trades: one is the return Mrs. Watanabe earned initially, which came solely from the interest rate differential; the other is the profit generated when the exchange rate changes over time—either because a low-interest-rate currency like the yen continues to depreciate or a high-interest-rate currency like the U.S. dollar continues to appreciate.
At this point, the mystery surrounding carry trade is unveiled, so let’s return to the most crucial question: Is carry trade truly 100 percent risk-free?
The answer is definitely no. When making financial investments, one must recognize that risk and return are inevitably interrelated; there is no such thing as a surefire, risk-free trade—and carry trades are no exception. Let’s continue with Mrs. Watanabe’s story. In 2007, a financial crisis swept across the globe,countries that had previously maintained high interest rates—such as the United States and Australia—began cutting rates one after another. Meanwhile, because Japan’s financial system remained stable, the yen was viewed as a safe-haven currency and continued to appreciate. Mrs. Watanabe and others who had been engaging in carry trades were caught off guard; those who had used leverage suffered margin calls and lost their entire investments.
Therefore, the risk of carry trades lies in the fact that exchange rates and interest rates in the market are not static; before entering into a trade, it is essential to clearly assess the future trends of the financial products involved.
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