Carry Trade Strategy — What Is It? (Backtest)

Last Updated on January 20, 2023

If you are active in the financial markets, you may have heard of carry trade, especially in currency trading. It is becoming increasingly popular among retail traders. But what does the carry trade strategy mean?

A carry trade strategy involves borrowing at a low-interest rate currency and converting the borrowed amount into another currency with a higher interest rate to invest in an asset that provides a higher rate of return.

In currency trading, it typically involves selling a currency with a low-interest rate and buying a currency with a higher rate. But the strategy can be applied to other assets when the borrowed amount is deployed into assets such as stocks, commodities, bonds, or real estate denominated in the second cu

Want to know more? Let’s dive in. At the end of the article, we provide some facts about carry trade backtests.

What is carry trade?

A carry trade strategy entails borrowing at a low-interest rate from one currency and investing in an asset that provides a higher rate of return in another currency.

In other words, borrowing in a low-interest rate currency and converting the borrowed amount into another currency. The proceeds would typically be deployed into certificates of deposits in the second currency that offers a higher interest rate, but they could also be invested in other assets, such as stocks, commodities, bonds, or real estate, denominated in the second currency.

While this kind of trade can be profitable, it is never without some risks, which include a sharp decline in the price of the invested assets and exchange risk, or currency risk, when it involves two different currencies. Given the risks involved, carry trades are appropriate only for investors with deep pockets and who “know what they are doing”.

Carry trade currency pairs

The carry trade strategy is most popular in forex trading, where it involves buying a currency pair with high-interest rate spreads — the base currency has a high-interest rate. In contrast, the quoted currency has a low-interest rate. For a long time, carry trades involved currencies like the Australian dollar or New Zealand dollar with the Japanese yen, as the interest rate spreads of these currency pairs are very high.

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Carry trade forex example

The first step in making a profitable carry trade is to find a currency that offers a high-interest rate and one that provides a low rate. What you need to do is to find and match the currencies with the highest and lowest yields. New Zealand and Australia often have the highest yields, while Japan has the lowest. Since currencies are traded in pairs, all you need to do to make a currency carry trade is to buy AUD/JPY or NZD/JPY through a forex broker.

Carry trade interest rates

Since the carry trade strategy involves borrowing from a lower interest rate currency and to fund purchasing a currency that provides a higher rate, interest rates play a key role in the strategy. The strategy aims to capture the difference between the rates, which can be substantial depending on the amount of leverage used.

So, as a trader, you have to look for currency pairs with high interest rate differentials. The funding currency (the currency with which the fund is borrowed) normally has a low interest rate, while the asset currency (the currency in which the asset is bought) must have a high interest rate.

What happens is that the central banks of funding currency countries, such as the Bank of Japan (BoJ) and the US Fed, often engaged in aggressive monetary stimulus, which results in low-interest rates. In their aim to kick-start growth during a recession, these central banks will use monetary policy to lower interest rates, creating opportunities for speculators who borrow the money with the hope to unwind their short positions before the rates increase.

Investors borrow the funding currency by shorting the currency and taking long positions in the asset currency, which has a higher interest rate. However, note that interest rates can be changed at any time, so you should stay on top of these rates by visiting the websites of the respective central banks. You can also get data from financial websites that regularly update the interest rates for the most liquid currencies in the world.

More importantly, financial markets always trade on future estimations – not based on what has happened in the past. Everyone can read the interest rates today, but what matters the most is the future rates.

For example, 2022 was a perfect example of how fast macro numbers can change. The FED has “tightened” aggressively to lower inflation expectations. Who would have thought that in early 2021? This makes carry trades liable to crash risk (more later). The forex rates move a lot based on these expectations.

Is carry trade risk free?

Carry trades can be profitable, but they are never without risks. The currency pairs with the best conditions for using the carry trading method tend to be very volatile. If the exchange rate stays the same or moves favorably, carry trades become profitable, but if the exchange rates become unfavorable, the losses could be substantial. While the daily interest payment from the interest rate differential will lessen the risk, it will likely not be enough to protect from trading loss.

Moreover, there can be a “carry trade unwind”, which is a global capitulation out of a carry trade that causes the “funding currency” to strengthen aggressively, wiping out the interest rate difference and triggering unfavorable market movement. This happened with the Japanese yen during the financial crisis in 2008.

So, don’t just go into a currency trade because of interest rate differential. Do a proper fundamental and technical analysis to be sure the trade feels safe, and the market has a great potential of moving in your favor before going for a trade. And use proper risk management.

That said, any risk management might not help you when markets start moving, it simply might be too late. Currencies can move a lot more than most people imagine. Just look at the USD/YEN:

Carry trade strategy

The moves are substantial, and you don’t need to be a genius to understand this can create havoc when gearing is involved.

Is carry trade arbitrage?

Carry trade and arbitrage are similar, but they are not the same unless when the arbitrage is based on interest rate differences. Arbitrage trading is when a trader tries to gain from discrepancies in the price of an asset or related assets. The trader may buy and sell currency prices that are divergent at the time but are extremely likely, at least according to empirical evidence, to rapidly converge, offering him some profits when he closes the trade.

On the other hand, carry trade aims to borrow at a low interest rate to invest in an asset that offers higher returns. It includes any trade where the investor buys a higher yielding asset, such as a high dividend stock, a high interest rate bond, or a commodity in strong backwardation (what is backwardation?), while shorting a similar but lower-yielding asset (such as a non-dividend paying stock, a low interest rate bond, a commodity in contango).

Note that covered interest rate carry trades are the same as arbitrages, but uncovered interest rate carry trades cannot be seen as arbitrages.

Carry trade formula

The key feature of a carry trade is the difference in interest rates, which is what the investor tries to earn. Thus, the carry trade formula is as follows:

Daily Interest = [(IRLong Currency – IRShort Currency ) / 365 days] x NV

Where:

  • IRLong Currency = interest rate per annum in the currency bought
  • IRShort Currency = interest rate per annum in the currency sold
  • NV = notional value

So, if you are long 1 lot of AUD/JPY with a notional of $100,000 and the interest rate for AUD is 5.10% (0.051) and that of the JPY is 0.1% (0.001), the daily interest you earn can be computed as follows:

[(0.051 − 0.001​) / 365] × $100,000

≅ $13.70 per day​

This interest is accrued every day, with a triple rollover given on Wednesday to account for Saturday and Sunday rollovers.

Carry trade strategy example

Carry trades can be with any asset.

So, let’s take a non-currency carry trade example. Let’s say your credit card issuer offers you a 0% interest for one year, and it requires a transaction fee of just 1% paid up-front. If you decide to take a $10,000 cash advance, your cost of funds would be just 1%. Let’s say you invest this $10,000 in an index ETF that yields 10% returns at the end of the one year when you are due to repay the loan. This is a carry trade that makes you a 9% (10% – 1%) profit, which amounts to $900 {$10,000 x (10% – 1%)}.

Carry trade risks

There are risks associated with a carry trade, but they depend on the assets involved. Here are the common risks:

  1. Exchange rate risks: This is the biggest risk in a currency carry trade. This risk arises because the forex market is exceptionally volatile and can change its course at any point in time. A small movement in exchange rates can result in massive losses. For instance, if you go long on NZD/JPY with the hope of earning from interest rate difference, you can incur a huge loss if the AUD were to fall in value relative to the Japanese yen.
  2. Interest rate risks: In this case, the interest rate difference disappears because the country of the investing currency reduces interest rates or the country of the funding currency increases its interest rates. When this happens, the trade becomes less profitable or not profitable at all, even if the exchange rate remains unchanged.
  3. Asset risk: This happens when the fund is invested in other assets, such as stocks or commodities. A sharp decline in the price of the invested assets would lead to a loss in the trade.

Bitcoin carry trade

A Bitcoin carry trade involves buying BTC and selling the futures contract. This works when they are in contango (what is contango?). A contango happens when the futures price is higher than the spot price.

Thus you can “lock in” the price differential because the futures price will normally get closer to the spot as the time to expiration diminish.

Carry trades and macro news

Any carry trade in forex is highly dependent on macro news or the national economy. We believe it’s next to impossible to predict any macro or economic indicator.

Why do you want to be exposed to random news?

Carry trade strategy (backtest and example)

A carry trade is a type of strategy that doesn’t really resonate with us. The reason is simple: it’s too “complicated” and involves too much leverage for our liking. You are exposed to crash risk. Furthermore, we want to have as little as possible to do with forex (we explained why we avoid forex).

We know traders that make carry trades in forex based on quantified strategies. Most of them don’t backtest, presumably because it’s complicated, but how do they know if this is a smart strategy without having historical performance based on strict trading rules? You can be pretty confident big institutional players have software that calculates the probabilities in carry trades at a whim.

Also, carry trade typically have a high win rate with a few big losers. Up until the financial crisis in 2008/09, a lot of traders made good money on carry trades. However, many of them “blew up” during the crisis, as they did again in 2022. Some forex pairs took years to recover after 2008.

The reason why is that carry trades have negatively skewed distribution (the exchange movements between high and low interests are negatively skewed). The winning days are many until the big loser comes around. Evidence might also suggest that one of the main reasons for the big losers is that investors themselves are forced to unwind huge positions. But after the storm, the future crash risk is reduced. It’s the ever-changing market cycle!

Example of a negatively skewed distribution:

Carry trade strategy risk
Mean-reversion strategies are not normally distributed: they have thin right tails and fat left tails.

Carry trade strategy video

We made a short carry trade strategy video.

carry trade strategy

We end the article with a compilation of some FAQs for the carry trade strategy:

Which currency/forex pair to choose for carry trade?

You need to pick one high interest rate currency and one low interest currency (if it’s a forex carry trade). However, you need to look at other factors as well.

Is a carry trade risk free?

Indeed not! As mentioned earlier in the article, you might have many (small) winners and a few big losers. It’s a form of strategy that is liable to crash risk due to the leverage.

How do make money on carry trades?

You make money on the interest differentials when you are right (and perhaps on the currencies). Furthermore, you also need to use leverage to make it worthwhile – thus increasing the risk.

What are carry trade risks?

While purchasing power parity (PPP) might work in the long term (interest rates are determined by the inflation rate), it can deviate substantially over short periods of time due to randomness. also, as mentioned before, crash risk is always lurking around the next corner.

How long can you hold a carry trade?

There is no limit to how long you can hold a carry trade. As long as the markets function, you can hold a position, and as long as you are solvent…..That said, it might not be a good idea to hold for a long time. There are many factors influencing what you should do.

How to choose currencies for carry trade?

The best advice is arguably to start with one of the major currencies, like the G7, for example. Smaller currencies, like the Norwegian krona or any emerging market currency, might be much more likely to react positively or negatively to random macro news.

What affects currency prices?

There are plenty of factors but interest differentials and subsequently inflation rates have proven to be pretty reliable for the long term. However, the short-term fluctuations might be big and deviate from the purchasing parity theory (PPT).

How to make a successful carry trade?

We suspect the best time is when any central bank announces an increase in interest rates, especially if it it’s not expected. That said, our best advice is to not delve much into carry trades. There are better options out there, for example, the stock market. We have presented plenty of stock trading strategies.

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