Currency carry trade — clear explainer
Definition
– Currency carry trade: borrow a currency with a low interest rate (the funding currency), convert it into a currency with a higher interest rate (the target or asset currency), and earn the interest-rate spread. Traders typically use leverage (borrowed capital) to amplify returns.
Key jargon
– Funding currency: the currency you borrow because its interest rate is low.
– Asset/target currency: the currency you buy or invest in because it offers a higher yield.
– Leverage: using borrowed capital to increase the size of a position relative to your equity, magnifying both gains and losses.
– Interest-rate differential (spread): the numeric difference between the target currency’s rate and the funding currency’s rate.
How it works — step‑by‑step
1. Identify a pair with a positive interest-rate spread (target rate > funding rate).
2. Borrow the funding currency (e.g., JPY) at its low rate.
3. Convert the borrowed funds into the target currency (e.g., USD).
4. Invest the proceeds in an interest-bearing instrument denominated in the target currency (or hold the higher-yielding currency cash position).
5. Collect interest on the investment while paying interest on the borrowed currency.
6. At the planned exit, convert the proceeds back into the funding currency and repay the loan. Profit = interest received minus interest paid, adjusted for any exchange-rate changes and costs.
Small worked example (numbers, assumptions listed)
Assumptions:
– Funding currency: Japanese yen (JPY) borrowing rate = 0.5% per year.
– Target currency: U.S. dollar (USD) investment rate = 4.0% per year.
– Exchange rate at start and end: 115 JPY per USD (no FX movement).
– Trade size: borrow 50,000,000 JPY.
– Ignore transaction costs, spreads, taxes, and margin interest beyond the quoted rates.
Steps and math:
1. Convert borrowed yen into dollars:
USD = 50,000,000 JPY ÷ 115 JPY/USD = 434,782.61 USD.
2. Invest USD at 4.0% for one year:
Ending USD balance = 434,782.61 × 1.04 = 452,173.91 USD.
3. Compute yen loan repayment including 0.5% interest:
JPY owed = 50,000,000 × 1.005 = 50,250,000 JPY.
Convert that back to USD at 115 JPY/USD:
USD required to repay = 50,250,000 ÷ 115 = 436,956.52 USD.
4. Profit in USD (before costs) = 452,173.91 − 436,956.52 = 15,217.39 USD.
Return as a percentage of initial USD invested = 15,217.39 ÷ 434,782.61 ≈ 3.5%,
which equals the interest-rate differential (4.0% − 0.