Understanding Carry Trades and How They Can Be Used: A Guide for CFOs and Treasurers

Published: August 27, 2024

Understanding the intricacies of various financial strategies is paramount for CFOs and treasurers. One such strategy is the carry trade, a concept that can significantly impact corporate finances and investment portfolios.

What is a carry trade?

A carry trade is a financial strategy where an investor borrows money in a currency with a low interest rate and invests it in a currency with a higher interest rate. The difference between the interest rates is known as the ‘carry.’

Key components of a carry trade are:

1. Interest rate differential: The difference in interest rates between two currencies in a currency pair and the primary driver of carry trades. The currency pairs with the largest interest rate differentials drive the potential for the most value.

2. Borrowing currency (funding currency): The currency within the pair with the lower interest rate.
3. Investment currency (target currency): The currency within the pair with the higher interest rate.

How does a carry trade work?

Here’s a step-by-step breakdown of a typical carry trade:

1. Borrow in a low-interest-rate currency: For example, an investor might borrow Japanese yen (JPY), which historically has had low interest rates.
2. Convert and invest in a high-interest-rate currency: The borrowed yen are then converted into a higher-yielding currency, such USD.
3. Earn the interest differential: The investor earns the interest rate offered in the US while paying back the lower interest rate in Japan.
4. Profit from the carry: The difference between the higher interest earned and the lower interest paid constitutes the profit from the carry trade.

Risks and rewards

Rewards

1. Interest Rate Differential: The primary reward is the interest rate differential between the two currencies – the larger the difference the larger the reward.
2. Currency Appreciation: If the investment currency appreciates against the borrowing currency, additional profits can be realised.

Risks

1. Currency risk: FX rate fluctuations can erode the profits from the interest rate differential. If the borrowing currency appreciates significantly, it can result in losses, which has the potential to be substantial where the market move is large and/or where leverage has been used.
2. Market volatility: Market conditions can change rapidly, affecting interest rates and FX rates.
3. Liquidity risk: In times of financial stress, the liquidity of the borrowing or investment currency can dry up, complicating the unwinding of positions.

The unwinding of carry trades can be triggered by various factors, primarily driven by either shifts in economic conditions or market sentiment. Changes in the economic outlook, such as concerns about the US economy or adjustments in central bank policies, often prompt investors to reconsider their positions, leading to the unwinding of carry trades. Additionally, geopolitical tensions and abrupt market reactions can cause sudden selloffs, resulting in the rapid unwinding of leveraged positions as investors seek to mitigate risk.

Real-world example

During a sharp sell-off in global markets, carry trade positions often need to be liquidated quickly. This was observed recently when JPY surged following a rate hike by the Bank of Japan, coinciding with the market’s adjustment to expectations of a lower Federal Funds rate in the US. This combination reduced the markets expectation of the interest rate differential between the currencies, prompting widespread unwinding of carry trades and putting pressure on tech stocks that had benefitted from these trades.

Managing carry trade risks

For CFOs and treasurers, managing the risks associated with carry trades involves:

1. Diversification: Avoiding over-concentration in specific currencies or assets can mitigate risk.
2. Hedging strategies: Using financial instruments to hedge against adverse currency movements.
3. Monitoring market conditions: Staying informed about global economic indicators and central bank policies to anticipate potential market shifts.

How corporates can use carry trades in risk management

Carry trades, while often associated with speculative financial strategies, can also be a valuable tool for corporate risk management. By utilising the interest rate differentials between currencies, corporates can enhance their financial strategies, manage FX risks, and optimise their capital structure.

Key considerations for corporates

1. Risk assessment: Thoroughly evaluate the underlying position and the risks associated with carry trades, including FX risk, interest rate risk, and market volatility.
2. Regulatory compliance: Ensure compliance with local and international regulations governing FX and borrowing activities.
3. Liquidity management: Maintain sufficient liquidity to manage potential margin calls or adverse FX movements.
4. Continuous monitoring: Regularly monitor the positions, market conditions, interest rates, and FX rates to adjust strategies as needed.
5. Integrated risk management: Incorporate carry trades into a broader risk management framework that includes various hedging and financial management tools – avoiding speculation.

It is key to understand all of the underlying exposures within the group and then utilise that knowledge to integrate it into a holistic corporate risk management approach. By utilising carry trades on a covered exposure, the trade can then be used to capture value and reduce portfolio risk, rather than speculating to target profit from the strategy in isolation.

Incorporating carry trades into corporate risk management can offer significant benefits, including optimising cash management, hedging FX risks, and reducing borrowing costs. However, it requires a strategic approach, robust risk assessment, and continuous monitoring to handle the associated risks effectively. By utilising the interest rate differentials between currencies, corporates can enhance their financial strategies and improve overall financial stability.

Potential corporate applications to benefit from carry trades

1. Enhancing cash management

Objective: Optimise the return on surplus cash balances.

Corporates can utilise carry trades to invest surplus cash in higher-yielding currencies. For example, a company with significant cash reserves in a low-interest-rate environment might borrow in its home currency and invest in a currency with higher interest rates. This approach can generate additional income, enhancing overall returns on idle cash.

Strategy:

• Identify currencies with favourable interest rate differentials
• Assess the liquidity and stability of the target currency
• Monitor FX rates to manage conversion risks effectively – this aspect is key given the risks outlined above

2. Hedging foreign exchange risk

Objective: Mitigate the impact of adverse FX movements on corporate earnings.

For companies with substantial revenues or expenses in foreign currencies, FX volatility can pose significant risks. Carry trades can act as a hedge by borrowing in a currency where the company has significant exposure and investing in the home currency or another stable currency.

Strategy:

• Match the borrowing currency with the currency in which the company has significant receivables or payables
• Use the interest rate differential to offset potential FX losses
• Combine carry trades with other hedging instruments such as forward contracts and options for comprehensive risk management
• Consider the timing of when cash flows are crystallised into the base currency to maximise any carry benefit (this could be structured at inception)

3. Managing interest rate exposure

Objective: Reduce borrowing costs and manage exposure to interest rate fluctuations.

Corporates can use carry trades to take advantage of lower interest rates in foreign markets. By borrowing in a currency with a lower interest rate and converting the proceeds into the home currency, companies can reduce their overall cost of capital thanks to this carry trade.

Strategy:

• Identify currencies with significantly lower interest rates compared with the home currency
• Evaluate the potential impact of exchange rate movements on the carry trade
• Structure the carry trade to align with the company’s debt maturity profile and cash flow requirements

4. Diversifying funding sources

Objective: Access diverse capital markets to improve financial flexibility.

Carry trades can enable corporates to tap into international capital markets, providing access to a broader range of funding sources. This diversification can enhance financial stability and reduce reliance on domestic capital markets.

Strategy:

• Assess the availability and cost of borrowing in different currencies
• Consider the regulatory and tax implications of international borrowing
• Balance the benefits of lower borrowing costs with the risks of currency exposure

5. Strategic investments

Objective: Optimise returns on strategic international investments.

For companies making strategic investments in foreign markets, carry trades can be used to fund these investments at a lower cost. By borrowing in the investment currency or another low-interest-rate currency, companies can enhance the returns on their foreign investments.

Strategy:

• Align the borrowing currency with the currency of the investment to minimise FX risks
• Utilise the interest rate differential to improve investment returns
• Monitor geopolitical and economic conditions in the investment region to manage risks proactively

Conclusion

Carry trades can offer attractive returns due to interest rate differentials between currencies. However, they also come with significant risks, particularly related to currency fluctuations and market volatility. By understanding the mechanics of carry trades and implementing robust risk management strategies, CFOs and treasurers can better navigate the complexities of global financial markets and make informed investment decisions.

Considering carry trades where there is an underlying exposure is a prudent approach for corporates. It helps in creating natural hedges, mitigating currency risk, enhancing cash flow matching and aligning with strategic goals. By focusing on these areas, companies can leverage carry trades to support their financial objectives as part of a holistic risk management approach while minimising the associated risks. This strategic alignment ensures that carry trades are not merely speculative punts but integral components of a comprehensive risk management and financial strategy.

Understanding and utilising carry trades requires not only a grasp of economic principles but also a keen and proactive awareness of global market dynamics. As markets continue to evolve, staying educated and vigilant remains essential for financial leaders.