Carry Trade
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When referring to an asset, the term “carry” means the return received (if positive) or cost incurred (if negative)of holding the asset. A carry trade is a currency trade in which low-yielding currencies are borrowed and high-yielding currencies are lent. A trader uses this strategy to benefit from the difference between the interest rates. The level of profits made from the trade depends on the difference in interest rates and the amount of leverage used by the investor.
When referring to an asset, the term “carry” means the return received (if positive) or cost incurred (if negative)of holding the asset. A carry trade is a currency trade in which low-yielding currencies are borrowed and high-yielding currencies are lent. A trader uses this strategy to benefit from the difference between the interest rates. The level of profits made from the trade depends on the difference in interest rates and the amount of leverage used by the investor. Currency carry trade correlates with the stability of the global financial and exchange rate.
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How is Carry Trade Done?
A currency carry trade is used as a strategy by investors. The investor sells a currency that has a relatively low interestrate and uses the funds thus acquired to purchase another currency that has a higher interest rate. In doing so, the tradercaptures the difference between these rates. This difference could be substantial, depending upon the amount of leverage that is chosen by the investor.
The theory of uncovered interest rate parity suggests that carry trades should not yield predictable profit.The argument behind this is that the interest rate difference between two countries should equal the rate at which the investorsexpect the low interest rate currency to rise against the high interest rate currency.
However, it is notable that foreign exchange rates may change in such a manner that the investor is compelled to pay back a more expensive currency. Since investors tend to sell the borrowed currency to convert it to other currencies, it may weaken the borrowed currency.
Benefits of Carry Trade
Carry trade is an important strategy of investment for profiting at times of global financial stability. Carry trade belongs to the currency trading market, which is one of the most developed markets of the world.
Risks of Carry Trade
The main risk associated with carry rate is that it depends upon the uncertainty of exchange rates. Another risk involved is that carry trade is undertaken with a high level of leverage. In such cases, huge losses could be suffered even with a small movement in the exchange rates. This can be prevented only through appropriate hedging.
