How do carry trades work?

Traders looking to “earn carry” will buy a high-yielding currency while simultaneously selling a low yielding currency. Carry trades are profitable because an investor is able to earn the difference in interest (the spread) between the two currencies as well as, ideally, capital appreciation. It lists the interest rates of several major countries as of Sept. 22.

The reason this trade is so popular is because it’s not limited to speculators. Imagine you are an investor in Switzerland who is earning an interest rate of 0.75-percent per year on your bank deposit denominated in Swiss francs (CHF). At the same time, a bank in Australia is offering 5.25 percent per year on a deposit denominated in Australian dollars (AUD). Seeing that interest rates are much higher at the Australian bank, wouldn’t you want to convert your Swiss francs into Australian dollars?

Large investors who are able to move money freely across borders will take advantage of higher yields offered abroad. By trading their deposit of Swiss francs paying 0.75 percent for a deposit of Australian dollars paying 5.25 percent, what these investors have effectively done is “sell” their Swiss franc deposit, and “buy” an Australian dollar deposit.

After this transaction they now own an Australian dollar deposit that pays 5.25 percent in interest per year — 4.50 percent more than the Swiss franc deposit. This is a carry trade.

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 trade them for Australian dollars. Australia attracts more capital because of the higher rates it offers.

This capital inflow increases the value of the currency. Aside from earning the 4.50 percent interest rate differential, traders engaging in such unhedged carry trades are also hoping, as in this example, their Australian dollar deposits appreciate in value against the Swiss franc.

Let’s look at another example. Assume the British pound (GBP) offers an interest rate of 4.75 percent, while the Swiss franc offers an interest rate of 0.75 percent. To execute the carry trade, an investor buys the British pound and sells the Swiss franc — or, buys the GBP/CHF currency pair. In doing so, he or she can earn a profit of 4 percent (4.75 percent in interest earned minus 0.75 percent in interest paid), as long as the exchange rate between the British pound and Swiss franc remains stable.