It is a type of negotiation in which the trader sells a certain currency with a low interest rate and then uses it to buy another currency that yields greater interest. The main purpose of the carry trading merchant is to capture the divergence in interest rates and to earn massive profits with the help of leverage.
Suppose you noticed that the interest rate in South Africa is 7%, while the current US interest rate is 1%. So you’re expected to get 6% difference between the two rates. For that to happen, you should borrow USD (the low yield currency whose issuer has set a relatively low interest rate) and buy a higher yielding currency – the South African Rand in this case. You can increase the amount of money to be gained by using leverage. For example, if you use a standard 10: 1 leverage ratio, you can have 60% profits. But there is a big risk behind this: the unpredictability of exchange rates. If ZAR fell against USD, you would lose a large part of your return.
So while the carry trade seems to be very attractive, it is very risky especially in troubled and uncertain times, where investors tend to rush to safe, low-yield ports, neglecting risky financial assets that offer greater returns.
Carry-through profits may not be the trader’s primary goal, but they can be a good complement to the gains he has from price fluctuations.
Example of a Merchant
Julian Robertson is one of the most famous carry traders in history. He used to trade USD / JPY. In the period from 1995 to 1998, this currency pair appreciated by more than 66%, partly thanks to carry traders buying high-yielding currencies and selling the yen. This trader could have 15% profit on interest rate differentials, plus the 66% he earned with the USD / JPY raise. Julian Robertson was trading USD / JPY with leverage and made a lot of money in that period. However, after 1998, with the yen’s sudden appreciation, it lost $ 2 billion.