Chapter 18
Fundamental Trading Strategy: The Leveraged Carry Trade
The leverage carry trade strategy is the quintessential global macro trade that has long been one of the favorite strategies of hedge funds and investment banks. On its most fundamental level, the carry trade strategy involves buying a high-yielding currency and funding it with the sale of a low-yielding currency. Aggressive speculators will leave the trade unhedged with the hope that the high yielding currency will appreciate in value relative to the lower yielding currency, allowing them to earn the interest rate differential on top of the capital appreciation. More conservative investors may choose to hedge the exchange rate component, earning only the interest rate differential. Although the differentials tend to be small, usually 1 to 3 percent if the position is leveraged 5 to 10 times, the profits from interest rates alone can be substantial. Of course it is important to remember that while leverage can magnify profits, it can also exacerbate losses. Capital appreciation generally occurs when a number of traders identify profit opportunities and pile into the same trade, driving up the value of the currency pair.
In foreign exchange trading, the carry trade is a popular way to take advantage of the notion that money flows in and out of different markets, driven by the law of supply and demand: with markets offering higher rates of return on investment attracting the most capital. Countries are no different—in the world of international capital flows, nations that offer the highest interest rates will generally attract more investment creating greater demand for their currencies. This helps to fuel the carry trade. The carry trade strategy is simple to master, but like all strategies, it contains risk. Carry trades performed extremely well between 2000 and 2007, failed miserably between 2008 and 2009, and recovered between late 2012 into 2015. The chance of loss can be great if you do not understand how, why, and when carry trades work best.
How Do Carry Trades Work?
To understand carry trading, it is important to first understand that currencies are always traded in pairs, so taking a carry trade involves buying a currency that offers a high interest rate and simultaneously selling a currency that offers a low interest rate. Carry trades are profitable when the exchange rate remains unchanged in value and investors are able to earn the difference in interest—or spread—between the two currencies, or when it appreciates in value, allowing the investor to earn the spread along with capital appreciation. If the exchange rate falls by more than the spread on the interest rate, it becomes a net loss for the investor.
Let's take a look at an example: Assume that the Australian dollar offers an interest rate of 4.75%, while the Swiss franc offers an interest rate of 0.25%. To execute the carry trade, an investor buys the Australian dollar and sells the Swiss franc. In doing so, he or she can earn a profit of 4.50% (2.75% in interest earned minus 0.25% in interest paid), as long as the exchange rate between Australian dollars and Swiss francs do not change. Figure 18.1 shows exactly how an investor would execute the carry trade.
Figure 18.1 Leveraged Carry Trade Example
To summarize: A carry trade involves buying a currency that offers a high interest rate while selling a currency that offers a low interest rate.
Why Do Carry Trades Work?
Interest rates are very important: Carry trades work because of the constant movement of capital into and out of different countries in search of the highest yield. Interest rates are the main reason why some countries attract more investment than others. There are three reasons why a country can pay a higher interest rate. First, if a country's economy is doing well (high growth, high productivity, low unemployment, rising incomes, etc.), it will be able to offer those who invest in the country a higher rate of return. Second, central banks can raise interest rates on fast growing economies with rising inflation. Third, countries with high debt to GDP ratios, low credit ratings, and/or inherent growth problems may also need to pay a higher interest rate to attract investment.
Investors prefer to earn higher interest rates: Investors who are interested in maximizing their profits will naturally look for investments that offer them the highest rate of return. When making a decision to invest in a particular currency, an investor is more likely to choose one that offers the highest rate of return, or in this case, interest rate. If several investors make this exact same decision, the country will experience an inflow of capital from those seeking to earn a high rate of return, and the currency should appreciate.
What about countries that are not doing well economically? Countries that have low growth and low productivity will not be able to offer investors a high rate of return unless they have a very poor credit rating and are forced to offer a higher rate to compensate for the risk of holding the country's bond or currency. With major economies, however, there will be times where growth is so weak that interest rates are brought to zero, providing investors with no meaningful return. The difference between countries that offer high interest rates versus countries that offer low interest rates is what makes carry trades possible.
Let's take another look at the carry trade example above in more detail.
Imagine an investor in Switzerland who is earning an interest rate of 0.25% per year on her bank deposit in Swiss francs. At the time, a bank in Australia is offering 4.75% per year on a deposit of Australian dollars. Seeing that interest rates are much higher with the Australian bank, this investor would like to find a way to earn this higher rate of interest on her money.
Now imagine that the investor could somehow trade her deposit of Swiss francs by paying 0.25% for a deposit of Australian dollars paying 4.75%. What she has effectively done is to “sell” her Swiss franc deposit and use those funds to “buy” an Australian dollar deposit. With this transaction, she now owns an Australian dollar deposit that pays her 4.75% in interest per year, 4.50% more than she was earning with her Swiss franc deposit.
This investor has essentially just done a carry trade by “buying” an Australian dollar deposit, and “selling” a Swiss franc deposit.
The net effect of millions of people doing this transaction is that capital flows out of Switzerland and into Australia, as investors take their Swiss francs and convert them into Australian dollars. Australia attracts more capital because of the higher rates it offers. This inflow of capital increases the value of the currency (see Figure 18.2).
Figure 18.2 AUDCHF Carry Trade Example 1
To summarize: Carry trades are made possible by the differences in interest rates between countries. Because they prefer to earn higher interest rates, investors will look to buy and hold high interest rate paying currencies.
When Will Carry Trades Work Best?
There will be times when carry trades work better than others. In fact, carry trades are the most profitable when there is a very specific attitude toward risk.
How Much Risk Are You Willing to Take?
The moods of people in general change over time—sometimes they may feel more daring and willing to take chances; other times they may be more timid and prone to conservativeness. Investors, as a group, are no different. Sometimes they are willing to make investments that involve a good amount of risk; other times they are more fearful of losses and look to invest in safer assets.
In financial jargon, when investors as a whole are willing to take on risk, we call this low risk aversion, which means they are in risk-seeking mode. Alternatively, when investors are drawn to more conservative investments and less willing to take on risk, we describe them as risk-averse.
Carry trades are the most profitable when investors have low risk aversion. This notion makes sense when you consider what a carry trade involves. Remember, a carry trade involves buying a currency that pays a high interest rate while selling a currency that pays a low interest rate. In buying the high interest rate currency, the investor is taking a risk because it is believed that a country needs to offer a higher interest rate to offset the risk of holding the currency. Also, while high interest rates attract investment, they can also hurt growth by raising the cost of borrowing. This creates uncertainty around whether the economy of the country will continue to perform well and be able to pay not just high but even higher interest rates. This risk is something a carry trade investor must be willing to take.
If investors as a whole were not willing to take on this risk, then capital would never move from one country to another, and the carry trade opportunity would not exist. Therefore, in order to return, carry trades require that investors as a group have low risk aversion, or be willing to bear the risk of investing in the higher interest rate currency.
To summarize: Carry trades will be the most profitable when investors are willing to bear the risk of investing in high interest paying currencies.
When Will Carry Trades Not Work?
So far, we have shown that a carry trade will work best when investors have low risk aversion. What happens when investors have high risk aversion?
Carry trades are the least profitable when investors have high risk aversion. When investors have high risk aversion, they are less willing as a group to take chances with their investments. This means they would be less willing to invest in riskier currencies that offer higher interest rates. Instead, when investors have high risk aversion they would actually prefer to put their money in “safe haven” currencies that pay lower interest rates. During this time, they may also opt to close or unwind their carry trades. In doing so, they would be buying the currency with the low interest rate and selling the currency with the high interest rate.
Returning to our earlier example, let's assume the investor suddenly feels uncomfortable holding the foreign currency, the Australian dollar. Now, instead of looking for the higher interest rate, she is more interested in keeping her investment safe. As a result, she swaps her Australian dollars for more familiar Swiss francs.
The net effect of millions of people doing this transaction is that capital flows out of Australia and into Switzerland as investors take their Australian dollars and convert them into Swiss francs. During this period of risk aversion, Switzerland attracts more capital due to the perceived safety of its currency, and the inflow of capital increases the value of the Swiss franc (see Figure 18.3).
Figure 18.3 AUDCHF Carry Trade Example 2
When investors have high risk aversion, they prefer to avoid the riskier high interest rate paying currency and instead invest in the safer, lower interest rate paying currency, which is the opposite of a carry trade.
To summarize: Carry trades will be the least profitable in periods of uncertainty when investors are unwilling to bear the risk of investing in high interest paying currencies.
The Importance of Risk Aversion
Carry trades will generally be profitable when investors have low risk aversion, and unprofitable when investors have high risk aversion. So before placing a carry trade it is important to understand the risk environment—whether investors as a whole have high or low risk aversion—and when it changes.
Rising risk aversion is generally beneficial for low interest rate paying currencies: Sometimes the mood of investors will change rapidly, and investors' willingness to make risky trades can change dramatically from one moment to the next. Often, these large shifts are caused by significant global events. When periods of risk aversion occur quickly, the result is generally a large capital inflow into low-interest-rate-paying “safe haven” currencies (see Figure 18.2).
For example, in the summer of 1998 the Japanese yen appreciated against the dollar by more than 20% over the span of two months, due to the Russian debt crisis and LTCM hedge fund bailout. Similarly, just after the September 11 terrorist attacks the Swiss franc rose by more than 7% against the dollar over a 10-day period. During the global financial crisis in 2008, we also saw big gains in the yen and the Swiss franc.
These sharp movements in currency values often occur when risk aversion quickly changes from low to high. As a result, when risk aversion shifts, a carry trade can turn from being profitable to unprofitable very quickly.
Risk Aversion and Carry Trade Profitability
As investor risk aversion goes from high to low, carry trades become more profitable as detailed in Figure 18.4.
Figure 18.4 Carry Trade Profitability
How do you know if investors as a whole have high or low risk aversion? Unfortunately, it is difficult to measure investor risk aversion with a single number. One way to get a broad idea of risk aversion levels is to look at bond yields. The wider the spread between the yields of bonds from different countries with similar credit ratings, the higher the investor risk aversion. Bond yields are readily available on major financial websites such as Bloomberg.com and Reuters.com. In addition, several large banks have developed their own measures of risk aversion that signal when investors are willing to take risk and when they are not.
Other Things to Bear in Mind When Considering a Carry Trade
While risk aversion is one of the most important things to consider before making a carry trade, it is not the only one. The following are some additional issues to be aware of.
Low Interest Rate Currency Appreciation
By entering into a carry trade, an investor is able to earn a profit from the interest rate difference, or spread, between a high interest rate currency and a low interest rate currency. However, the carry trade can turn unprofitable if for some reason (like the risk aversion examples earlier), the low interest rate currency appreciates by a significant amount.
Aside from rising risk aversion, improving economic conditions within a low interest paying country can also cause its currency to appreciate. An ideal carry trade will involve a low interest currency whose economy is weak and has low expectations for growth. If the economy were to improve, however, the country might then be able to offer investors a higher rate of return through increased interest rates. If this were to occur—again, using the previous example, say that Switzerland increased the interest rates it offered—then investors may take advantage of these higher rates by investing in Swiss francs. As seen in Figure 18.3, an appreciation of the Swiss franc would negatively affect the profitability of the Australian dollar–Swiss franc carry trade. (At the very least, higher interest rates in Switzerland would negatively affect the carry trade's profitability by lowering the interest rate spread.)
This same sequence of events may currently be unfolding for the Japanese yen. Given its zero interest rates, the Japanese yen has for a very long time been an ideal low interest rate currency to use in carry trades (known as yen carry trades). This situation however, may be changing. Increased optimism about the Japanese economy has recently led to an increase in the Japanese stock market. Increased investor demand for Japanese stocks and currency has caused the yen to appreciate, and this yen appreciation negatively affects the profitability of carry trades like Australian dollar (high interest rate) versus Japanese yen.
If investors continue to buy the yen, the yen carry trade could start to become unprofitable. This further illustrates the fact that when the low interest rate currency in a carry trade (the currency being sold) appreciates, it negatively affects the profitability of the overall carry trade position.
Trade Balances
A country's trade balance (the difference between imports and exports) can also affect the profitability of a carry trade. We know that when investors have low risk aversion or are risk seeking, capital will flow from the low interest rate paying currency to the high interest rate paying currency (see Figure 18.2) but this does not always happen.
One reason is because countries with large trade surplus can still see their currencies appreciate in low risk environments because running a trade surplus means that the country exports more than it imports. This creates naturally demand for the currency.
The point of this example is to show that even when investors have low risk aversion, large trade imbalances can cause a low interest rate currency to appreciate (as in Figure 18.3). And when the low interest rate currency in a carry trade (the currency being sold) appreciates, it negatively affects the profitability of the carry trade.
Time Horizon
In general, a carry trade is a long-term strategy. Before entering into a carry trade, an investor should be willing to commit to a time-horizon of at least six months. This commitment helps to make sure that the trade will not be affected by the “noise” of shorter-term currency price movements.
To summarize: Carry trade investors should be aware of factors such as currency appreciation, trade balances, and time horizon before placing a trade. Any or all of these factors can cause a seemingly profitable carry trade to become unprofitable.