Carry trade is a strategy that many investors use to profit from the interest rate differential between two currencies. Suppose, Japanese Yen (JPY) deposits give only 0.35% interest while the New Zealand Dollar (NZD) deposits give a much higher interest of 4.35%. By selling JPY and buying NZD, investors can profit from the interest rate differential of 4% between the two currencies.
Money always keeps on moving from a low yield market to a high yield market. This is one of the fundamental laws of the markets. Carry traders utilize this fundamental law of the market to profit from the interest rate differential between the two countries. Investing in high yield assets is what every investor wants. When a Japanese saver finds that she can get a much higher return of 4.35% on the NZD deposit as compared to getting only 0.35% on her JPY deposit, she will sell JPY and buy NZD.
Of course, she will not be the only person doing this. There will be millions of depositors who would want to profit from the high interest rate offered on NZD. When millions of depositors sell JPY and buy NZD, JPY will depreciate and NZD will appreciate. This exchange rate appreciation also will add to the profits of the carry traders.
So, carry trade strategy works when investors as a group are willing to take the risk of investing in a high yield currency. However, during times of high risk aversion, carry trade strategy fails. During times of high risk aversion, capital will start flowing in the reverse direction as investors try to seek safe haven currencies.
This was the market dynamics that makes carry trading a profitable strategy when there is low risk aversion amongst the investors. If you use leverage, you can substantially increase your profits. For example using a leverage of 5:1, can increase the interest rate different to 20%. But, as always using leverage is a risky strategy. It can multiply your profits when the market is cooperating with you and it can substantially multiply your losses if the market refuses to cooperate and suddenly turns against you.
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