Unlocking the Potential of Carry Trade in Financial Markets

What if you could turn the difference in global interest rates into a steady income stream? Carry trade offers precisely that, allowing investors to borrow in low-interest-rate currencies and invest in high-yield assets.

In this article, we’ll explore the key advantages and potential pitfalls of carry trade, equipping you with the knowledge to navigate this popular strategy effectively.

What is Carry Trade?

Carry trade is an investment strategy where investors borrow funds in a currency with a low interest rate and invest them in assets denominated in a higher currency. The goal is to profit from the interest rate differential between the two currencies.

This approach takes advantage of global economic conditions, leveraging low borrowing costs to maximise returns in higher-yielding markets. Carry trade is widely used in forex trading and broader financial markets to generate consistent income from interest rate disparities.

How to Execute a Carry Trade in Traditional Markets?

One of the most well-known examples of carry trade is the classic “Yen-Dollar” strategy. For years, investors borrowed in Japanese yen, benefiting from its low interest rates, and invested in U.S. dollar assets offering significantly higher yields.

This strategy was profitable as long as the interest rate differential remained favourable and the yen’s exchange rate against the dollar stayed stable. However, in July 2024, a sudden surge in the yen’s value disrupted this balance, highlighting the inherent risks of carry trade.

Other Examples of Carry Trades:

Borrowing Swiss francs (CHF), known for low interest rates, to invest in assets denominated in New Zealand dollars (NZD), which typically offer higher yields. Utilising low-interest euro (EUR) loans to invest in Turkish lira (TRY) assets with higher returns, though this comes with elevated risks due to the lira’s volatility.

Example: Carry Trade Using Yen and Australian Dollars (AUD)

• Borrow Low-Interest Currency: An investor borrows Japanese yen at an annual interest rate of 0.1%.
• Convert and Invest: The borrowed yen is converted into AUD and invested in high-yield Australian bonds, which offer, for example, 4% annual returns.
• Long Position on AUD/JPY: The investor takes a long position on the AUD/JPY pair, aiming to profit from a potential appreciation of the Australian dollar against the yen.
• Hedge Currency Risk: To mitigate the risk of unfavourable currency movements, the investor simultaneously opens a short position in AUD/JPY futures for an equivalent amount, locking in the current exchange rate.
• Result: The investor earns the yield differential (4% from Australian bonds minus 0.1% borrowing cost in yen).

The short futures position safeguards against potential declines in AUD/JPY, protecting the overall profit from currency volatility. This approach highlights the balance between opportunity and risk in carry trades, where careful planning and hedging are crucial for success.

How to Execute Carry Trade in the Cryptocurrency Market?

Decentralised Finance (DeFi) opens up many opportunities for investors to maximise returns on their crypto assets. Within this dynamic space, carry trade strategies can be effectively implemented.

Example Scenario:

• Crypto Asset 1 (ABC): A USD-pegged stablecoin with an annual borrowing rate of 2%.
• Crypto Asset 2 (XYZ): A volatile cryptocurrency with limited supply, offering an 8% annual yield on a DeFi platform.
• Exchange Rate: 1 XYZ = 30,000 ABC.

Steps:

• Borrow Stablecoin: An investor borrows 100,000 ABC at a 2% annual rate through a centralised exchange or DeFi lending platform.
• Convert to Volatile Asset: The 100,000 ABC is converted into XYZ at the current rate (1 XYZ = 30,000 ABC), resulting in 3.33 XYZ.
• Invest in DeFi Protocol: The investor deposits the 3.33 XYZ into a DeFi protocol, offering an 8% annual return on XYZ deposits.
• Hedge Exchange Rate Risk: To mitigate the risk of XYZ price fluctuations, the investor opens a short position in XYZ/ABC futures or options for 3.33 XYZ at the current exchange rate.

Outcome After One Year:

• Earnings from XYZ Investment: 3.33 XYZ * 8% = 0.266 XYZ.
• Borrowing Costs in ABC: 100,000 ABC * 2% = 2,000 ABC.
• Convert XYZ Back to ABC: Assuming the rate remains 30,000 ABC per XYZ, the investor converts 3.596 XYZ (initial deposit + yield) back to ABC, resulting in 107,880 ABC.
• Hedging Results: With no change in the exchange rate, the short position incurs no loss.

Net Profit:

• Earnings in ABC: 0.266 XYZ * 30,000 = 7,980 ABC. After deducting borrowing costs (2,000 ABC), the net profit is 5,980 ABC.

By leveraging the interest rate differential between a stablecoin and a volatile crypto asset, the investor achieves nearly 6% profit while minimising exchange rate risk through hedging. This example illustrates how carry trade can be effectively applied in cryptocurrency.

Pros and Cons of Carry Trade

Carry trade is a popular long-term investment strategy. Like any strategy, it comes with its own set of advantages and risks, requiring thorough planning and risk management for successful execution.

Pros:

• Steady Income: Provides stable interest income from holding currency pairs with high interest rate differentials.
• Long-Term Strategy: Suitable for risk-averse investors looking for long-term returns.
• Diversification Benefits: Combining multiple assets with varying yields reduces the likelihood of significant losses, as gains from one asset can offset losses from another.
• Used by Professionals: Widely adopted by investment banks and hedge funds, ensuring the strategy’s reliability when implemented correctly.
• Relatively Safe Instruments: Using safer assets reduces the risk of significant losses and may also lower potential returns.

Cons:

• Currency Risk: Sudden strengthening of the borrowed currency can eliminate profits or result in losses when converting back to the original currency.
• Capital Lock-Up: Requires long-term capital commitment, potentially missing out on higher-yielding opportunities.
• Market Volatility: Economic shifts and market volatility can impact profitability, requiring careful monitoring and risk management.
• High Capital Requirements: Significant positions are often needed to make the strategy worthwhile, which can lead to large capital lock-ups.
• Leverage Risks: Using leverage to amplify returns increases exposure to liquidation risks, particularly during market fluctuations.
• Thin Margins in Cash-and-Carry: The price spread between futures and spot markets may be small, requiring substantial capital to generate meaningful profits.
• Risks of Perpetual Swaps: Perpetual swaps carry higher risks compared to futures due to potential market shifts from contango to backwardation, which can lead to delayed or unprofitable exits.

Conclusion

Carry trade is a time-tested strategy that offers the potential for steady, long-term returns by leveraging interest rate differentials. By carefully managing risks, diversifying investments, and staying informed about market conditions, traders can maximise the rewards of carry trade while minimising potential downsides. For those willing to commit to a disciplined approach, this strategy remains a powerful tool in finance.

About Concordex

Concordex is a cutting-edge Decentralised Exchange (DEX) that operates on the Concordium Blockchain. Renowned for emphasising institutional-grade security, transparency, and user-centric design, Concordex offers various services, including staking, swapping, and perpetual trading. With a mission to bridge the divide between traditional finance and decentralised systems, it offers users an unparalleled trading environment.

Website | Twitter | Discord