Before the financial tsunami in 2008, carry trades were almost regarded as a trading model that guaranteed profits, which made it a maker of global liquidity floods. So, what exactly is a carry trade, and how does it ensure a profit?
First of all, in order to form the basis of trading spreads, investors need to hold at least two different assets, and the interest earned by holding these two assets needs to be different, which can generate a spread. In daily life, the deposit business of banks is actually a kind of spread trade. When we deposit money in the bank, we are actually lending money to the bank in disguise to charge short-term loan interest. The bank then lends the money out and charges long-term interest on the loan. Since the interest rate on long-term loans is higher than that on short-term loans, banks can use this to earn the difference in interest.
But what we call a carry trade today usually refers to a currency carry trade. In this transaction mode, investors will borrow money from a country that offers low interest rates, and then convert the funds into the currency of a country with a high interest rate before lending, thus having the opportunity to earn the interest difference between the two currencies .
Why is it said that there is an opportunity to earn a spread? This actually shows that carry trades are risky. There are two key factors to determine whether carry trades can bring benefits to investors:
1. Fluctuations in interest rates.
The fluctuation of interest rates between two trading currencies is one of the factors that determine whether investors can make profits. If the central bank of the country where the funds are borrowed raises the interest rate, it will directly increase the repayment cost of the carry trade (the interest paid to the country where the funds are borrowed), thereby narrowing the interest rate difference between the two currencies, so investors need to bear the interest rate risks caused by volatility.
2. Fluctuations in exchange rates.
Exchange rate fluctuations between two trading currencies are another factor that determines whether an investor can make a profit. If the exchange rate of the trading currency fluctuates sharply, the potential loss may be higher than the interest income brought by the carry trade, and eventually the investor may lose all his money. Therefore, in order for carry trades to bring benefits, the prerequisite is that the fluctuations in the foreign exchange market must be stable, so as to avoid the risks caused by exchange rate fluctuations.
In fact, carry trades appear more often in the foreign exchange market. As interest rates in Japan have remained low (0.0%), the yen has become the most commonly lent currency in carry trades. Investors usually borrow yen and then exchange it for other currencies with high interest rates, such as the Australian dollar, to make money by taking advantage of the interest rate difference between the Japanese yen and the Australian dollar. However, as mentioned above: carry trades cannot guarantee that investors will make a profit. If the yen appreciates against the Australian dollar, and its increase exceeds the interest rate difference between the two currencies, the losses caused by exchange rate fluctuations will exceed the profits brought by the interest rate difference, causing investors to lose instead of profit.
Therefore, carry trades are actually the same as most transactions, and investors need to bear certain risks. Sound risk management must also be employed when earning income from the interest rate differential between two currencies, while keeping an eye on exchange rate fluctuations. If investors can combine prudent risk control management, they can effectively increase the probability of successful transactions. If you want to know more about financial and financial knowledge or details of foreign exchange investment, please visit the official website of Hantec Foreign Exchange: http://www.hantec-au133.com/
The above content is provided by Hantec Forex. If you have any questions or comments, please leave a message for discussion.
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