Carry trade strategy traditionally aims to profit from the interest rate differential between high and low-interest rate economies. What is a carry trade example? An investor can use similar security to borrow in a low-interest rate country like Japan at 1 percent and lend/invest in a higher interest country such as the USA at 3 percent to lock-in a return equal to the rate difference of 2 percent. As Japan and the USA do not use the same currency, the investor needs to convert his yen to dollars to return borrowed money and complete the trade. The profitability of this strategy depends on the exchange rate used to convert money back to dollars. As the future exchange rate is uncertain, carry trade has significant currency risk and as such is not arbitrage.
The word carry originated in commodity trading where an investor earns a positive or negative return from bearing an asset. For example, gold carries a negative carry due to inherently generating no return but costing money to store safely. Example of a positive return from carry is holding a bond until maturity or holding a dividend-paying stock where investor earns a return on coupons/dividends rather than speculatively buying/selling the underlying asset. Even though carry investments can be made with all asset classes, it usually refers to the currency carry. The main idea behind currency carry trade strategy is the failure of the uncovered interest rate parity (UIRP), by which an investor takes advantage of an often nonfunctioning relationship between interest rates and future exchange rates across economies. The UIRP stipulates that difference in spot interest rates should be equal to the difference of future exchange rates. However, empirical evidence suggests that foreign exchange markets can take a long time to converge to equilibrium which gives investors the opportunity to exploit this disparity.
The divergence of foreign exchange markets from UIRP (also known as Fisher hypothesis) has been puzzling economists for decades. Cumby and Obsfeld (1981) are one of the first empirical studies that reject the UIRP. Moreover, other following studies confirm this finding. A survey of evidence of this trend is described in Hodrick (1987), Froot and Thaler (1990), and Lewis (1995). No rational reasons initially appeared to explain this phenomenon. Later various risk-based interpretations of the puzzle emerged such as foreign exchange risk premium, home bias and restrictions and frictions in international equity transactions.
An important contribution to the field is of Bacchetta and Wincoop (2007) showing that failure of UIRP is due to only a small portion of foreign currency holdings being actively managed giving rise to low UIRP convergence. Lustig and Verdelhan (2007) describe a novel currency investment strategy, the dollar carry trade, which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. They find that return on currencies with high-interest rates have higher loading on consumption growth risk such that low-interest-rate currencies provide domestic investors with a hedge against domestic aggregate consumption growth risk. Jylha, Lyytinen, and Suominen (2008) argue that foreign investor capital leads to an appreciation of the carry long currencies and is widely correlated with hedge fund indices.
Further evidence on carry trade activity from Heath, Galati and McGuire supports the previous findings of consistent excess returns earned by FX carry investors. Commonly the long leg of the trade is invested in a short term foreign government bond or an interest rate swap. These strategies are popular with both institutional and retail investors using margin accounts. Some argue that FX carry trade profits are attributed to holding fat tail risk also called the peso problem. However, Burnside et al. (2010) show that excess returns with high Sharpe ratios are attainable even after hedging out large currency reversals using currency options.
All in all, the currency carry trade looks like a stable profit making strategy that is widely used. However investors should be aware of fat tails and rare but large losses from the unwinding of the carry.