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What Is A Currency Carry Trade in Forex Markets?

By Samuel Becker · July 22, 2021 · 3 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Is A Currency Carry Trade in Forex Markets?

Carry trade is a strategy used by some traders who invest in currency markets to take advantage of differences in interest rates. In a carry trade, an investor buys or borrows a security or asset at a low interest rate, and then uses it to invest in another security or asset that provides a higher rate of return.

Here’s what you need to know about how a carry trade strategy works and the risks associated with it.

What Is a Carry Trade?

In a carry trade, forex traders borrow money at a low interest rate in order to invest it in an asset with a higher rate of return. In the forex markets, the currency carry trade is a bet that one foreign currency will hold or increase its value relative to another currency. Of course, this strategy hinges on whether or not interest rates and exchange rates are in the traders’ favor. The wider the exchange rate between two currencies, the better the potential returns for the investor.

Recommended: What Is Forex Trading?

Even so, a carry trade strategy can be a relatively simple way to increase an investor’s returns, assuming they understand the difference in interest rates. In that way, it’s similar to understanding “spread trading” as they relate to stocks.

How Do You Execute a Carry Trade?

Carry Trade Example

Imagine that the US dollar has a 1% interest rate, but the British pound has a 2% interest rate. A trader could take 100 US dollars, and then invest that 100 dollars into the equivalent number of pounds (according to the exchange rate), and earn a higher return in interest. The discrepancy in interest rates allows traders to take advantage and earn higher returns.

This is a rather simplistic carry trade example, professional traders and investors can engage in complex carry trade strategies, and even employ the use of a carry trade formula to help them figure out expected returns, and whether the strategy is worth pursuing in a given situation.

Rather than simply buying one currency with another, traders often execute a carry trade that involves borrowing money in one currency and using it to purchase assets in another currency. In this scenario, traders want to borrow the money at the lowest possible interest rate, and do so using a weak or declining currency.

That can create higher profits when they close the deal and pay back the borrowed money. In general, carry trade is a short-term strategy, rather than one focused on the long-term.

Recommended: Short-Term vs Long-Term Investments

Is a Carry Trade Risky?

The concept of a carry trade is simple, but in practice it can involve investment risk. Most notably, there’s the risk that the currency or asset a trader is investing in (the British pounds in our previous example) could lose value. That could put a damper on a trader’s expected returns, as it would eat away at the gains the difference in interest rates could provide. Currency prices tend to be very volatile, and something as mundane as a monthly jobs report released by a government can cause big price changes.

The greater the degree of leverage an investor uses to execute a carry trade, the higher the potential returns–and the larger the risk. In addition to currency risk, the carry trade is subject to interest rate risk. Given the risks, carry trades in the currency markets may not be the most appropriate strategy for investors with a low tolerance for risk.

The Takeaway

Carry trades are one way for investors or traders to generate returns, although the approach involves some risks that aren’t present in other types of investment strategies. While the carry trade concept is straightforward, it can quickly get complex when institutional investors put it in place.

If you’re ready to start investing in less complicated investments, a great way to start is by opening an account on the SoFi Invest® brokerage platform, which allows you to buy or sell stocks, ETFs, trade crypto and more.

Photo credit: iStock/akinbostanci


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