It is a strategy whereby an investor sells a certain currency with a relatively low interest rate and uses the receipts to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.
For example, in a rupee-carry trade, a trader borrows $10 million from an American bank, converts the funds into Indian rupees and buys a bond for the equivalent amount. Let’s assume that the bond pays 8% and the American interest rate is set at 2%. The trader stands to make a profit of 6% as long as the exchange rate between the countries do not change. Many professional traders use this trade because the gains can become very large, if leveraged.
The big risk in a carry trade is the uncertainty of exchange rates. These transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.
Source : ET
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