News on Carry Trade

Carry Trade: Consider the Possible Risks and High Potential Returns

In a carry trade, an investor is borrowing at a low-interest rate in one currency and investing it in an asset that is offered for a higher rate of return in another currency. The investor is profiting from the interest rate differential. Carry trade has possible risks and high potential returns.

Hedging And Currency Risk

Exchange Rates

Hedging is a trading strategy to reduce risk in particular investments. Currency risk is a risk caused by foreign exchange rate fluctuations.

In a carry trade, the investor is exposed to currency risk if the value of the currency in which they borrowed decreases relative to the currency in which they invested. One way to mitigate currency risk is to hedge the investment. To hedge, open an offsetting position in the foreign exchange market.

For example, if an investor borrows in Japanese yen and invests in US dollars, they could hedge their investment by selling US dollars forward. If the value of the yen decreases relative to the dollar, the investor will lose money on their investment. However, they will make a profit on their hedge, which will offset some of their losses.

Volatility And Interest Rates

Interest Rates And Carry Trade Returns

Carry trade returns are influenced by the interest rate differential between the two currencies involved. The greater the interest rate differential, the higher the potential return. However, the greater the interest rate differential, the greater the risk. This is why carry trade is often considered a high-risk, high-reward strategy.

Interest rates can change rapidly, which can lead to unexpected losses in a carry trade. For example, if the interest rate on the currency in which the investor borrowed increases, the investor's interest expenses will increase. This will reduce their profit margin and could even lead to a loss.

Volatility

Volatility is a measure of how much the price of an asset fluctuates. The higher the volatility, the greater the risk. In a carry trade, the investor is exposed to volatility in both the currency market and the market for the asset in which they invested.

For example, if the investor borrows in a low-volatility currency and invests in a high-volatility asset, they are taking on a greater risk than if they invested in a low-volatility asset. This is because the value of the high-volatility asset could fluctuate significantly, which could lead to losses.