A carry trade defines as a trading strategy that involves borrowing at a low-interest rate and investing in an asset that gives a better rate of return. A carry trade is usually supported borrowing during a low-interest rate currency and converting the borrowed amount into another currency. Generally, the proceeds would be deposited within the second currency if it offers a better rate of interest . The proceeds also might be deployed into assets like stocks, commodities, bonds, or land that are denominated within the second currency.
The carry trade strategy is best fitted to sophisticated individual or institutional investors with deep pockets and a high tolerance for risk.
Although carry trades can contain potential financial rewards, this strategy also can pose significant risks, including-
- The risk of a pointy decline within the price of the invested assets
- The implicit exchange risk, or currency risk, when the funding currency differs from the borrower’s domestic currency
Currency risk in a carry trade is seldom hedged because hedging would either impose an additional cost or negate the positive interest rate differential if currency forwards—or contracts that lock in the exchange rate for a time in the future—are used.
Carry trades are popular when there’s ample appetite for risk. However, if the financial environment changes abruptly and speculators are forced to unwind their carry trades, this will have negative consequences for the worldwide economy.