Today my topic of focus is on carry trade. I have received several emails on the issue of carry trading so I decided to write one or two things about it.
What is Carry Trade?
A carry trade in forex is when a trader tries to generate profit from the variance in interest rates, referred to as the interest rate differential, between the two currencies in a forex pair.
Carry trading in forex involves positive and negative strategies.
Positive carries involve borrowing a low-interest rate currency as you buy a currency with a high-interest rate.
Traders get into a positive carry trade assuming that the higher interest rate currency will maintain the same interest rate or even appreciate.
In doing so, they will receive interest rate payments equal to the interest rate differential between the two currencies in the pair, based on the size of their initial investment.
Negative carries on the other hand involve borrowing a high-interest rate currency while buying a currency with a low-interest rate.
Traders entering a negative carry trade assume that the lower interest currency will grow in appreciation relative to the higher interest rate currency.
At the start, a negative carry trade will suffer a net loss as the trader has to pay interest for holding the position, however, this could become a net gain that counters any losses incurred, in the event where the higher interest rate currency depreciates to the level of the lower interest rate currency.
How do Carry Trades Work?
As I have outlined above, a carry trade refers to when a trader borrows a high or low-interest rate currency.
From this, the trader uses the borrowed money to purchase another currency that pays a higher interest rate.
As a trader, you can generate income on the variance between the interest rates.
To view the interest rates for every currency, you can check any up-to-date list of central bank interest rates.
For example, if you engaged in the trading process of borrowing Japanese Yen and bought U.S. Dollars, you will end up making a rollover.
What this means is that you would be generating income on the interest out of the fact that the interest rate of the Federal Reserve is higher than the interest rate of the Bank of Japan.
Additionally, what do you think of a 0% cash advance given by credit card lenders for a limited time?
The purpose is the investment in an asset with a higher gain.
This is what carry trade does.
Nevertheless, carry trade involves risks and is therefore not for everyone.
Traders who wish to engage in carry trading should be able to handle the risks and pressure involved.
Not everyone’s trading psychology is built to withstand strong emotions. This is something that a trader builds with time.
Main Components of Forex Carry Trade
Changes in interest rates
The main component of the carry trade focuses on the difference in the interest rate between the two traded currencies.
Even when the exchange rate between the two currencies doesn’t change, the trader will gain profit from the overnight interest payment.
With time, however, central banks find it important to change interest rates and this is a possible risk to the carry trade strategy.
Exchange rate depreciation/appreciation
In the second component of the carry trade strategy, the focus is on the exchange rate of the two currencies.
A trader here hopes that the target currency will appreciate when long.
When the currency appreciates, the payoff to the trader includes the daily interest payment as well as any unrealized profit from the currency.
Nevertheless, the profit the trader is able to see, due to the target currency gaining value, is only realized when the trader closes the trade.
A trader can lose money when the target currency loses its value against the funding currency, and here the capital depreciation takes out the positive interest payments.
Example of a Carry Trade
Let’s assume you go to a bank and borrow $15,000.
The bank’s lending fee is 1.5% of the $15,000 annually.
With the amount borrowed, you turn around and buy a $15,000 bond which pays 6% a year.
What would your profit be?
It would be 4.5 % a year.
That is the difference between the interest rates.
Maybe by now you think that this doesn’t sound as exciting or as profitable as catching swings in the market.
Does that sound interesting to you?
I can give you an idea. A 2% difference in interest rate for an account that has 1:30 leverage becomes 60% annual interest.
Benefits and Shortcomings of Currency Carry Trades
The main benefit of currency carry trades is that, other than possibly gaining profit from any differences in price from the two currencies in the pair, you are also gaining interest on your active position.
Additionally, should you have opened your position with leverage, the interest gained will be based on the entire size of your position and not on the deposit required in opening it.
Do note however, that even though leverage can increase your gains, it can also increase your losses.
This is one thing that many forex traders fail to put into account.
At any given time, you should focus on what you stand to lose and not what you stand to gain. This way you will have a better perspective of whether a trade is worth taking or not.
Some currencies that are used in currency carry trades are so volatile and this could lead to risk mainly during economic uncertainties.
Also, decisions on interest rates are determined by a country’s own central bank, and this means that should the interest rate spread between the two currencies in a transaction be narrow, a carry trade receiving interest can end up in a net loss very fast.
When the currency that you are borrowing as part of a positive currency carry trade all of a sudden strengthens against the currency in its pair, you could end up losing a lot.
You should therefore purpose to manage your trading risk.
Risk Management in Carry Trading
It is evident that even as carry trading is possibly lucrative, it has numerous risks involved.
This is due to the high volatility of the best currencies that are used in this type of trading.
When there is a negative market sentiment among traders in the currency market it could have a great effect on “carry pair” currencies.
Lack of effective risk management, could have a trader’s account wiped out by an unexpected and bad turn.
It is most advisable to enter into carry trades when fundamentals and market sentiment support the trades.
Carry trades are best entered during times of positive market sentiment, since at this time investors are in a buying mood.
In conclusion, before you indulge in any form of carry trade, first ask yourself if you are capable of handling the inherent risk.
As a good trader, your focus should not only be on the possible profit, but also on the possible losses.
This helps to take charge of trading emotions that come with greed and FOMO.
And as I always say, only risk that which you are willing to lose. This helps to remove all the emotions hence giving you a clear mind to conduct the analysis when trading. This is something that you should apply when indulging in a carry trade.