Carry trade

Interest rates are not the same everywhere. Some currencies pay very little. Others pay a lot.

A carry trade takes that gap and turns it into a position. You borrow money in the cheap currency. You convert it. You invest it in the currency that pays more. You keep the difference.

The workbook names the usual actors. The cheap side is a currency with low interest rates, such as the Japanese Yen or the Swiss Franc. The expensive side is an emerging market currency, and the workbook's own example of one is the Indian Rupee. The profit is the interest rate differential.

The currency you borrow is called the funding currency. The yen is the workbook's prime example: it is preferred as a funding currency for carry trades by hedge funds. The Swiss franc is described as a popular funding currency too.

There is a catch, and it is the exchange rate. You have to convert back at the end. If the currency you borrowed has gone up against the one you invested in, the differential you earned can vanish.

The workbook's definition (Chapter 1, footnote to section 1.2.1): a carry trade involves borrowing funds in a currency with low interest rates (such as the Japanese Yen and the Swiss Franc) and investing these funds in assets denominated in a currency with high interest rates (emerging market currencies such as the Indian Rupee), thus earning the interest rate differential.

Note what the workbook does and does not give. It defines the trade and names the funding currencies, but it supplies no interest rates and no worked carry-trade figures anywhere in the syllabus. The illustration below is therefore labelled as illustrative, built on figures the workbook does give elsewhere.

Why the yen and the franc. Chapter 1 describes each in its own right:

Liquidity is the reason. A funding currency has to be borrowable in size at any hour.

Why the rupee is on the receiving end. Section 1.6.4 supplies the pull. There is normally a positive relationship between real interest rates and the value of the INR. When real rates are high, more money flows into Indian debt from Foreign Portfolio Investors, and those dollar inflows tend to make the rupee stronger. So a carry trade into rupee assets can earn the rate gap and a currency gain at the same time — which is exactly what makes the trade crowded, and what makes an unwind violent.

How it connects to derivatives. Chapter 3's interest rate parity says the forward rate should already price the interest differential in. A carry trade is, in effect, a bet that it does not fully do so, or that the spot rate will not move the way parity implies.

A yen-funded rupee carry trade. The 6.5% rupee yield is the workbook's own figure for a 10-year G-Sec (section 1.6.4). The yen borrowing rate of 1% and the JPYINR levels are illustrative — the workbook gives no funding rate.

A fund borrows yen worth Rs 10 crore for one year and buys Indian government bonds.

Case A — the yen stays put. The fund repays the same rupee value of yen and keeps Rs 55 lakh on Rs 10 crore. That is the carry.

Case B — the yen strengthens 4% against the rupee. Repaying the loan now costs 4% more in rupees.

Case C — the yen strengthens 8%.

The differential is 5.5%, so anything more than a 5.5% move in the funding currency wipes it out. A carry trade is an interest position with a currency position bolted on, whether the trader wanted one or not. A fund that wanted only the 5.5% would have to hedge the yen leg — and hedging it, under interest rate parity, costs roughly the differential it was trying to earn.

The term appears in Chapter 1, section 1.2.1 (Major Currencies), where the Japanese Yen is described as the preferred funding currency for carry trades by hedge funds, with the definition in the footnote on the same page; the Swiss Franc paragraph repeats the funding-currency point. Section 1.6.4 (The Real Interest Rate in the Economy) supplies the rupee side. Questions are recall-level: which currencies are used for funding, what a carry trade earns, and which way the borrowing and investing legs run. Do not expect a computation — the workbook gives no rates to compute with.

• Borrow low, invest high. Reversing the legs is the commonest slip: you borrow the yen, you do not invest in it.
• The yen and the Swiss franc are funding currencies, not carry destinations. The rupee is the workbook's example of a destination.
• What is earned is the interest rate differential, not a currency gain. Any currency gain is a separate and unhedged risk.
• A carry trade is not a hedge. It deliberately takes currency risk; hedging that risk away removes the reason for the trade.
• The definition sits in a footnote, which is exactly the sort of place a recall question is mined from.
• Do not confuse carry trade with cost of carry in futures pricing. They both involve interest, but one is a position and the other is a pricing component.