Carry Trade Strategy

Carry Trade Strategy: Example, Rules, Backtest, Analysis, Returns, Python Code

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.

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?

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

Key Takeaways:

  • Carry trade involves borrowing in a low-interest rate currency and investing in higher-return assets in another currency.
  • Risks include exchange rate volatility and changes in interest rates that can impact profitability.
  • Backtesting shows carry trade strategies can yield profits, but outcomes heavily depend on market conditions and leverage used.
  • Interest rates play a crucial role, aiming to profit from the differential between borrowing and investment returns.
  • Carry trades are not risk-free, with potential for significant losses due to market volatility and leveraged positions.

What is carry trade?

A carry trade strategy involves 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 would typically involve deploying the proceeds into certificates of deposits in the second currency that offers a higher interest rate. Still, 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 trading strategy – backtest, performance, returns, example

Let’s show you a backtest of a carry trade strategy. We trade the USD/JPY, but use the US dollar index as a variable for when to buy and sell the forex pair (we use the spot price for the backtest).

We make two carry trade trading strategies and backtest them:

  • A carry trade where we borrow at the 10-year Japanese yield and lend at the 10-year US yield every month; and
  • A carry trade with a filter.

We make the following trading rules:

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When we implemented the trading rules, we got the following equity curves:

Carry trade trading strategy
Carry trade trading strategy

Any forex pair went more or less flat over the period, while both the carry trade strategy and the carry trade strategy with a filter made profits.

The following table shows the returns and performance matrices:

USDJPY carry trade example
USDJPY carry trade example

The carry trade strategy example might show a low CAGR (annual return), but remember that it is an unleveraged return.

Was the strategy just due to luck? We backtested different settings:

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As you can see, the strategy returned pretty decent returns no matter the setting we used.

The backtest is done by using Python. For your convenience, we have the full code for you:

Carry trade example Python code
Carry trade example Python code

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.

Carry trade forex example

The first step in making a profitable carry trade is to find a currency with a high interest rate and a low rate.

You need 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 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 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 leverage used.

So, as a trader, you must 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 perfectly shows 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. There is no free lunch in the financial markets!

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.

Currencies and forex traders are at the mercy of geopolitical events, and macro events tend to be volatile and liable to “black swans”. Thus, any carry trade has a lot more risk than most imagine. Just one bad trade can wipe out many profitable ones.

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 divergent currency prices at the time but is 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 daily, with a triple rollover on Wednesday to account for Saturday and Sunday rollovers.

Carry trade strategy example

Carry trades can be with any asset. Let’s describe an example:

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 falls 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 futures contracts. 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 expiration date approaches.

Carry trades and macro news

Any carry trade in forex is highly dependent on macro news or the national economy. We believe predicting any macro or economic indicator is next to impossible. Why news may not be useful to your trading.

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 as little as possible to do with forex (we explained why we avoid forex).

We know traders who 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 that big institutional players have software that calculates the probabilities in carry trades at a whim.

Also, a carry trade typically has a high win rate with a few big losers. Until the financial crisis in 2008/09, many 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 is that carry trades have negatively skewed distribution (the exchange movements between high and low interests are negatively skewed). There are many winning days until the big loser comes around. Evidence might also suggest that one of the main reasons for the big losers is that investors are forced to unwind huge positions. However, 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 FAQ

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 choose one with 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?

A carry trade is not risk free. 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 to make money on carry trades?

When you are right on carry trades, you make money on the interest differentials (and perhaps on the currencies). Furthermore, you need to use leverage to make it worthwhile, thus increasing the risk.

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 and you are solvent, you can hold a position. That said, it might not be a good idea to hold for a long time. Many factors influence what you should do.

How to choose currencies for carry trade?

The best advice is arguably to choose with one of the major currencies, like the one in 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 affecting currency prices, 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).

Does the purchasing power parity (PPP) work?

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

How to make a successful carry trade?

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

How does the carry trade strategy work in currency trading?

In currency trading, the carry trade strategy works by selling a currency with a low interest rate and using the proceeds to buy a currency with a higher interest rate. The borrowed funds are then invested in assets such as certificates of deposit, stocks, commodities, bonds, or real estate denominated in the higher-yielding currency.

What are carry trade currency pairs?

Carry trade currency pairs are those with high-interest rate differentials. In forex trading, this often involves buying a currency pair where the base currency has a high-interest rate, and the quoted currency has a low-interest rate. Popular carry trade pairs historically include the Australian dollar or New Zealand dollar against the Japanese yen.

How are interest rates crucial to the carry trade strategy?

Interest rates are crucial to the carry trade strategy because they fund the purchase of the lower-interest currency.

Are carry trades risk-free?

But carry trades are not risk-free. Risks include exchange rate volatility, interest rate changes that reduce profitability, and asset risk. Interest rates play a key role in the carry trade strategy. The goal is to capture the difference between the interest rates of the funding currency (borrowed at a low rate) and the asset currency (invested for a higher return). This interest rate differential forms the basis for potential profits.

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