Today, we cover the carry trade.
What is the carry trade?
The carry can be undertaken in the fixed-income and FX markets.
The Carry Trade in currency markets is when you borrow in the currency with the low interest rate, and then invest that in the currency with the higher interest rate.
Below is a chart illustrating a typical example where the carry trade strategy could have been best applied. The chart shows a steady increase of the GBP/JPY pair in 2005 and 2006, spawned, among other things, by carry traders going long to obtain the interest rate differential.
A risk of the currency carry is that it exposes the trade to currency risk. In the example above, this could occur by the Yen depreciating against sterling reducing returns. One way of reducing this risk is by hedging, which I will cover in my next post.
For the bond market, this refers to a trade where you borrow and pay interest in order to buy something else that has higher interest. For example, with a positively sloped term structure (short rates lower than long rates), one might borrow at low short term rates and finance the purchase of long-term bonds.
As a result, traders reap a return from this yield differential.
Check out the video below for more detail: