Carry Trade as an Investment Strategy: Merits and Demerits
By Samuel Ighoyota Akporhiunuvwiyo
The concept of carry trade is a very important concept in the financial market. A carry trade is when you borrow from a low interest rate economy to invest in a high interest economy.
This is very common in the security market because a smart investor can make more money on the difference between interest rates of the two economies.
For example, Sammie, a portfolio investor, borrowed on January 5, 2019, the sum of $5000 with the interest rate of 2 percent from the United States economy and decided to invest in Nigeria, which presently has its benchmark interest rates at 13.50 percent.
Before investing his $5,000 loan in the Nigerian economy, he first converted the money to Naira, the local currency, which gave him a total of N1.8 million ($1 is equivalent to N360).
If Sammie invested this money in treasury bills in Nigeria with an average rate at 13 percent, at maturity, this investment tool he chose would have yielded him N2.03 million, which is equivalent to $5650.
From this, Sammie would have made a profit of $650 from the carry trade, pending in the US rate of 2 percent.
Now to the important question, is carry trade safe?
Carry trade is not entirely safe, although we are investing in a risk-free security. For carry trade to be successful, the risk of devaluation to foreign currency must be very low.
From the above illustration, assuming there was devaluation ($1 exchanging at N450 within the period), the total return of N2.03 million from the investment will become $4520, resulting into a loss of $480 from the carry trade.
Also, one can actually get into a lot of trouble with the carry trade, especially if you are leveraged. The reason it is not entirely safe is because although your interest rate is risk free, there is position risk in your trade especially trading FOREX.
However, if you manage your risk properly and enter the market at a good spot, it can be possible to build up a nice interest-bearing position, while minimizing your position risk.
So, this is how carry trade works. Now that you understand the benefits and downsides of this investment strategy, I hope you can use this information in your trading.
One thing you must note is that carry trade is not for everyone, but if you manage the risks, it’s another trading strategy you add to your arsenal.