Unit 2 · Level 2 · Currencies & FX
The carry trade
Borrow Japanese yen at nearly 0%, buy Mexican pesos earning 10%, pocket the difference: the famous 'carry trade'. It can grind out profits for years. But whenever finance offers you yield for seemingly nothing, ask the Formiga question: where does it come from? With carry, the answer is that you're being paid to stand in front of a rare but violent snapback.
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What you get asked
What IS a carry trade?
You fund cheap and invest rich, earning the gap between the two interest rates. The classic version borrowed yen at near zero to buy anything that yielded more.
A carry trade earns the rate gap until the ___ currency suddenly strengthens and wipes out years of yield.
Your debt is in the funding currency. If the yen you borrowed jumps 15%, your loan just grew 15%, which can erase several years of collected interest in a week.
Where does the carry trade's 'free' yield actually come from?
Traders describe carry as 'picking up pennies in front of a steamroller'. The steady income is compensation for occasionally being flattened. The yield IS the risk premium.
In late July 2024 the Bank of Japan raised rates and within days the yen jumped. Yen carry trades:
Leveraged carry positions were forced to close all at once; Japan's Nikkei fell over 12% in a single day (its worst since 1987) and the shock rippled into US stocks. A tiny rate hike, a global tremor.
Order the anatomy of a carry-trade unwind
Crowded trades die in stampedes. Years of calm, steady carry income can vanish in days, the same lopsided payoff the risk lessons in the Trading course warn about. 🐜
The rest of this unit
Why the euro in your pocket rises and falls against the rest of the world.