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The "carry trade" is a popular and potentially lucrative forex strategy, and with the advent of ETFs, traders can now implement the strategy simply by going long either of two specially designed funds.

A carry trade is a strategy by which a trader sells a certain currency with a relatively low interest rate and uses the funds 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.

Here’s an example of a "yen carry trade": a trader borrows 1,000 Japanese yen from a Japanese bank, converts the funds into US dollars, and buys a bond for the equivalent amount. Let’s assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% as long as the exchange rate between the countries does not change.

Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then he/she can stand to make a profit of 45%.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the US dollar were to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Also, 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.

See related: The Forex Carry Trade Explained

Currency Arbitrage and the Carry Trade

Using a stable currency, such as the greenback, which has held a low interest rate steady for years, forms a great base for the trade. Low volatility and reliance on futures contracts combined with this stability allows for the use of leverage. Adding leverage allows better returns than the average 2%-4% interest-rate spreads between developed economies.

While currency arbitrage was once the realm of large institutional investors and pension funds, the exchange traded product boom has brought the strategy to the average Joe investor’s portfolio.

Allocating a small portion of a long-term trading portfolio to the carry trade may make sense as it is an uncorrelated asset class and can provide diversification benefits. Using exchange-traded funds makes this simple and quite affordable. There are two funds that exploit currency arbitrage.  

NEXT: 2 ETFs Designed with Carry Trades in Mind