Investing in High-Yield Markets with Low-Interest Currency: A Comprehensive Analysis of Spread Trading

In recent years, the most talked-about investment strategy in the financial markets has been carry trade. Since 2022, as the global interest rate hike cycle began, the divergence in central bank policies across countries has become evident. This approach of exploiting interest rate differentials between currencies for arbitrage has increasingly attracted investor attention. Many people often confuse carry trade with arbitrage, but in essence, they are fundamentally different. This article will delve into the operational mechanism of this strategy, potential risks, and how to apply it in practical operations.

Core Mechanism of Carry Trade

Carry trade is an investment activity that exploits differences in interest rates across countries, often also called interest rate arbitrage. Simply put, investors borrow funds in countries with low interest rates, convert them into currencies of countries with higher interest rates, and invest to earn the interest rate spread.

For example, from 2022 to 2024, the Taiwan-US interest rate differential was such that Taiwan banks had borrowing rates around 2%, while US fixed deposit rates reached 5%. The 3% difference is the potential profit for investors. Even more advantageous is if the US dollar appreciates against the Taiwan dollar (e.g., from 1:29 to 1:32.6), allowing investors to also profit from exchange rate gains.

However, this seemingly prudent trading strategy hides complex risks. During Argentina’s debt crisis, the country implemented nearly 100% interest rate policies to curb currency depreciation, yet the peso still plummeted by 30% in a single day. This illustrates that high interest rates do not necessarily mean currency appreciation; many other fundamental economic factors influence exchange rate movements.

Three Major Risks of Carry Trade

Investors engaging in carry trade need to be cautious of the following risks:

1. Exchange Rate Fluctuation Risk

This is the most direct and significant risk. Even if the interest rate differential is sufficient to cover borrowing costs, adverse exchange rate movements can quickly wipe out all gains, or even lead to capital losses. Many traders amplify returns using high leverage, which further magnifies losses caused by exchange rate volatility.

2. Interest Rate Narrowing Risk

Interest rate spreads are not fixed. For example, Taiwanese insurance companies in earlier years sold policies with fixed dividends of 6%–8%, while fixed deposit rates were 10%–13%. Today, deposit rates have fallen to 1%–2%, placing heavy burdens on these policies. The same applies to mortgage investments—initially, rental income exceeded mortgage interest, but if mortgage rates rise or rents fall, the interest spread can turn into a loss.

3. Liquidity Risk

Not all financial products have good liquidity. Some products bought at 100 units may only be sold at 80 units; some require high transaction fees. Insurance contracts can only be canceled by policyholders, and insurance companies have no such rights. This means investors may be trapped in losing positions without the ability to cut losses in time.

Hedging Methods

Traditional hedging involves using financial instruments that move inversely to the underlying asset to offset risk. For example, a Taiwanese factory receiving a $1 million order but waiting a year for payment can lock in exchange rate risk through a forward FX contract (SWAP), sacrificing potential gains from currency appreciation.

However, in practice, the cost of locking in the exchange rate often cannot be fully offset by expected gains. Therefore, investors usually hedge only when facing uncontrollable risks like long holidays, while in other cases, they directly convert the investment back into the original currency to close the position.

The Largest Global Carry Trade: Yen Interest Rate Arbitrage

The largest-scale interest rate arbitrage activity globally involves the Japanese yen. Japan has become the preferred borrowing currency due to its unique market characteristics: political stability, relatively stable exchange rate, and extremely low interest rates. Moreover, yen borrowing is very easy.

For years, the Japanese government has implemented loose monetary policies, maintaining zero or even negative interest rates to stimulate domestic consumption. Although Europe also adopted long-term zero interest rate policies, international investors borrowing in euros for arbitrage are far less common than in yen.

Case 1: Cross-border Asset Allocation

International capital first borrows Japanese yen bonds or loans at low interest rates (around 1%) from the Bank of Japan, then invests in high-yield assets or financial products in the US, Europe, and other countries. Even if the yen appreciates at maturity, causing exchange rate losses, the extremely low borrowing costs often allow the overall investment to remain profitable.

Case 2: Japanese Stock Investment Strategy

Post-pandemic, with excess global liquidity, Warren Buffett believed US stock valuations were too high and shifted focus to the Japanese market. He issued Berkshire bonds to borrow at low interest in Japan, using the funds to buy high-value Japanese stocks. Subsequently, he pushed for companies to increase dividends, buy back shares, and improve liquidity, demanding stock prices to return above net asset value. This strategy yielded over 50% profit in just two years.

The key is that borrowing in yen to invest in Japanese stocks avoids exchange rate risk (same currency), and dividend yields are usually higher than bond yields, creating a thicker interest rate spread. For Buffett, this operation carries relatively low risk because he can directly influence corporate decisions; unless the investment target ceases to be profitable, risks are manageable.

Carry Trade vs. Arbitrage: Fundamental Differences

Arbitrage typically refers to “risk-free arbitrage,” where investors exploit price differences of the same product across different markets, engaging in low buy and high sell activities based on time, information, or regional disparities.

In contrast, carry trade involves directly holding assets with interest rate differentials for investment, inherently bearing risks such as price fluctuations and interest rate changes. This is the fundamental distinction. In short, arbitrage seeks certainty of returns, while carry trade involves earning interest rate spreads while accepting risk.

Key Points of Successful Carry Trade Strategies

Successful carry trading first requires grasping the duration of the trade. Investors must pre-determine the holding period and select matching investment targets accordingly.

Second, analyzing the relative price trend of the investment target over a period is crucial. Choosing assets with observable trends, such as the medium- to long-term trend of USD/NTD, can significantly increase success probability.

Therefore, investors interested in carry trade should thoroughly prepare dynamic data on interest rates and exchange rates across countries. Only by deeply understanding the correlation of these variables can they more effectively identify and execute arbitrage opportunities while managing risks.