Carry Trade Strategy — What Is It? (Backtest)

Last Updated on August 28, 2022 by Oddmund Groette

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 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 currency.

Want to know more? Let’s dive in.

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, it means 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.

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 while the quote currency has a low interest rate. For a long time, carry trades involve 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.

The first step in making a profitable carry trade is to find a currency that offers a high interest rate and one that offers 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. In fact, 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 the data from financial websites that regularly update the interest rates for the most liquid currencies in the world.

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.

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, a commodity in strong 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 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 an exceptionally volatile one, 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.

Carry trade strategy (backtest and example)

A backtest of a carry trade strategy is coming soon.

Similar Posts