Understanding Carry Trade in One Article: How to Profit from Interest Rate Differentials?

In recent years, Carry Trade (interest rate differential trading) has become a focal topic in the capital markets. Since 2022, central banks around the world have adopted different monetary policies, prompting investors to actively seek arbitrage opportunities created by interest rate gaps. However, many still misunderstand the essence, risks, and operational methods of carry trade. This article will delve into this investment strategy.

What is Carry Trade? What is the core logic?

The core of interest rate differential trading is borrowing low-interest currencies to invest in high-interest assets, earning the interest rate spread in between.

A straightforward example is: borrowing TWD from a bank at 2% interest, converting the funds into USD, and depositing at 5% interest, with the 3% difference being the trading profit. It sounds simple, but the actual operation is much more complex.

Since 2022, this strategy has been particularly popular because the pace of interest rate hikes varies significantly across countries. The US has aggressively raised rates, while many Asian countries have increased rates more gradually, and investors have sensed the opportunity. In 2022, the TWD to USD exchange rate was about 1:29, and by 2024, it had appreciated to 1:32.6. In some cases, investors not only profit from the interest rate spread but also gain additional returns from currency appreciation.

However, not every interest rate hike cycle results in currency appreciation. Take Argentina as an example: the government raised interest rates to nearly 100% to stabilize the exchange rate, but on the day the policy was announced, the peso depreciated by 30%. This illustrates that while carry trade can be profitable, it also hides significant risks.

The three major risks of carry trade

Investors often overlook the following risks when engaging in carry trade:

1. Exchange rate volatility risk

This is the most direct and easily understood risk. After borrowing low-interest currencies, exchange rates can fluctuate significantly. Even if the interest rate spread is favorable, a reverse movement in exchange rates can lead to losses on the entire investment.

2. Interest rate change risk

The interest rate differential that investors lock in may narrow. For example, Taiwanese insurance companies once sold policies promising annual dividends of 6%–8%, with deposit rates as high as 10%–13%. But as Taiwan lowered interest rates, deposit rates fell to 1%–2%, causing huge losses for these insurers. The same applies to mortgage investments—initially, rental income exceeded mortgage interest, seeming stable, but when mortgage rates rise or rents fall, the interest spread turns into a loss.

3. Liquidity risk

Not all financial products can be quickly liquidated. Some investments may face high transaction costs or be difficult to sell in urgent situations. Insurance products are even more so; policyholders have the right to cancel, but companies cannot quickly exit their positions.

How to hedge carry trade risks?

A common hedging method is using financial instruments that move inversely to the investment target to lock in some risks.

For example, an exporter signs a USD 1 million order but receives payment after one year. The company can use forward FX swaps(SWAP) to lock in the current exchange rate, avoiding the risk of exchange rate fluctuations after one year. However, this approach incurs additional costs, and most investors will assess whether it is worthwhile based on actual circumstances. Usually, hedging tools are used only when facing special risks (such as market closures during consecutive holidays).

The yen interest rate differential trade: the world’s largest arbitrage story

The largest carry trade globally is borrowing Japanese yen to invest in other assets. Why is the yen the first choice?

Japan has unique advantages: political stability, currency stability, extremely low interest rates, and a long-standing loose monetary policy by the Bank of Japan that encourages lending. Although Europe has also implemented zero interest rates, far fewer investors borrow euros for arbitrage compared to borrowing yen, mainly because Japanese financial institutions have relatively relaxed restrictions on external loans.

Two main ways of yen arbitrage

Strategy 1: Borrow yen to invest in high-yield countries’ assets

International investment firms collateralize with USD or their home country assets, borrow large amounts of low-interest yen from the Bank of Japan (interest rates around 1%), and then invest in high-interest currencies, bonds, or even real estate in the US, Europe, etc. Because the cost of borrowing yen is extremely low, even if there is a currency loss later, the overall investment often remains profitable.

Strategy 2: Borrow yen to invest in Japanese stocks

Post-pandemic, global central banks have loosened monetary policy significantly. Warren Buffett believes US stock valuations are too high and has turned to the Japanese stock market. He raised funds by issuing yen-denominated bonds through Berkshire Hathaway and invested in high-dividend Japanese stocks. Subsequently, he pressured the board to increase dividends and stock liquidity. Within just two years, the return on investment exceeded 50%. The beauty of this approach is that it completely avoids exchange rate risk—borrowing yen to invest in Japanese stocks profits from dividends, not from currency appreciation.

Interest rate differential trading vs arbitrage trading: what’s the difference?

Many people confuse the two, but they are fundamentally different:

• Arbitrage(Arbitrage): Usually risk-free, involves exploiting price differences of the same product across different markets for buy low, sell high.
• Carry Trade(Carry Trade): Directly invests in products with interest rate gaps, inherently bearing price volatility risk from the start.

This is the most fundamental difference between the two.

How to develop an effective carry trade strategy?

The key to successful interest rate differential trading is timing. Investors must first determine the holding period before selecting suitable investment targets.

Next, analyze the historical price trends of the target, choosing assets with technical patterns that can be anticipated. For example, USD/TWD exchange rates often exhibit cyclical characteristics.

Finally, investors should prepare a detailed analysis of the relationship between each country’s interest rates and exchange rate movements, so as to identify the best carry trade opportunities and reduce the risk of sudden market reversals.