Carry trades use interest rate differences between currencies to make profits – the yen has long been particularly popular as a cheap financing currency. But with rising interest rates in Japan and falling yields in the USA, this strategy is becoming less attractive, while interest rate differential certificates are becoming more interesting again for private investors.
What is a Carry Trade?
The basic principle of a carry trade, as Trading.de explains, is simple: investors borrow capital in a currency with a low interest rate, the so-called funding currency, and at the same time invest this money in a currency with a higher interest rate. The profit arises from the interest rate difference between the two currencies as well as from the exchange rate changes in the currency pair.
The interest rate differential between the countries involved is crucial to the success of a carry trade. In practice this means that the Low interest ratescurrency is sold and the high-yield currency is bought. Constellations with the Japanese yen as the funding currency, which is often opposed to the Australian dollar or the US dollar as the target currency, are particularly common.
The Yen Carry Trade
The Japanese yen was by far the most popular funding currency from the beginning of 2016 to the beginning of 2024. The reason: The key interest rate was constant at minus 0.1 percent during this period. Not only was the yen particularly cheap to finance, professional market participants were even able to achieve negative effective refinancing costs in the currency swap market due to the interest rate difference and high basis spreads. This made the currency the ideal basis for carry trades for years, as Reuters explains.
An example illustrates the attractiveness: Anyone who borrowed yen at an interest rate of minus 0.1 percent in November 2023 and invested the capital in US dollars, which at that time yielded around 4.5 percent interest, could mathematically achieve an annual return of around 4.6 percent – just through the interest difference. It is precisely this stable interest rate differential that made the so-called yen carry trade so popular over the years.
Intra-currency carry vs. classic currency carry
Carry strategies are always based on the same basic idea: exploiting interest rate differences. While a classic carry trade works across national borders, an interest rate difference certificate uses the spreads within a currency.
With classic currency carry, you borrow capital in a low-interest currency – such as the Japanese yen – and invest it in a high-interest currency such as the US dollar. Profit arises from the difference in interest rates, the main risk lies in the exchange rate.
Interest rate difference certificates, on the other hand, remain in one currency, for example the euro, and rely on the difference between short-term and long-term interest rates, typically the spread between the 2-year and 10-year interest rates. Here, the steepness of the yield curve determines the return. If the curve falls flat or inverts, the yield shrinks.
In short: With an interest rate difference certificate you speculate on the shape of the interest rate curve, with a classic carry trade on international interest rate differences.
Carry strategies in check: Is it worth chasing interest rates for private portfolios?
Whether exploiting interest rate differences is worthwhile for private investors depends primarily on the implementation chosen.
Interest rate differential certificates often offer capital protection at the end of the term and are more predictable than currency transactions. You can diversify your portfolio sensibly because your income is largely independent of share prices, as the savings bank explains. If the yield curve remains flat or inverts, i.e. short-term interest rates are higher than long-term interest rates, the annual interest coupon is significantly lower or is eliminated completely.
Classic carry trades via currency CFDs are unsuitable for private investors due to their complexity. The main risk lies in volatility: even minor exchange rate fluctuations can wipe out the interest rate advantage within a very short period of time. There is also the cost risk due to fluctuating refinancing rates. If the interest rates of the funding currency rise or brokers adjust their margin fees, the strategy risks slipping into the loss zone even if the exchange rate remains stable.
M. Maier / editorial team finanzen.net
