The Carry Trade

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Introduction

When you buying a currency pair like AUD/USD you are buying the first currency (AUD) and selling the second currency (USD).  Basically The Carry Trade involves buying the currency with a high interest rate and selling the currency with a low interest rate - profiting from the interest rate differential.  

In effect you are sitting on a financial instrument with a higher interest rate than the one you sold.  The interest rate differential gained on a pair can be 3% or more.  When you introduce leverage, say of 10x leverage, that becomes 30%.  On 20x leverage, 3% becomes 60% - you get the idea?  This interest is added (or subtracted if you've bought the lower interest currency and sold the higher one - this is called the negative carry) from your position on a daily basis.

Important Considerations of The Carry Trade

The selection of the currency pair can make the difference between a losing and a profitable trade. When selecting the currency pair, traders want to observe the following: 
  • The trader wants to make sure he is buying the currency that has the higher interest rate and is selling the currency that has a lower interest rate in comparison.  
  • Understanding the role that interest rates play in the FX market is crucial. A country offering high interest rates will attract more capital as investors seek to capitalize on higher returns.  
  • The carry trade works best under 'risk on' trading environments and tends to break down under 'risk off' periods.  During 'risk off' periods traders fly to safe investments like the USD or JPY.  If the outlook of a country's economy looks as good, then chances are that that country's central bank will have to raise interest rates in order to control inflation - This is good for carry trade because a higher interest rate means a bigger interest rate differential.  On the other hand, if a country's economic prospects aren't looking too good, then nobody will be prepared to take on the currency if they think the central bank will have to lower interest rates to stimulate their economy - There's a flight to safety
  • The trader also wants to view the health of the economy for the currency pair to ensure the market will move to his/her favour.  Bond Spreads help here.  Technically we look for trending pairs.
  • Risk management rules still apply - you must always understand your potential losses.
  • This correlation is a long term strategy. Government policy takes time to implement, but nonetheless bond spreads can help to establish long run trend
  • Short term fluctuations in the market can create risk situations for traders.
Essentially, the trader will be buying a currency with a stronger economy and selling the currency with a weaker economy. the most commonly used currencies to fund carry trades are the Japanese yen and the Swiss franc because of their countries' exceptionally low interest rates. 

The popularity of the carry trade is one of the main reasons for the strength seen in pairs such as the Australian dollar and the Japanese yen (AUD/JPY), the Australian dollar and the U.S. dollar (AUD/USD), the New Zealand dollar and the U.S. dollar (NZD/USD), and the U.S. dollar and the Canadian dollar (USA/CAD).

The Simple Carry Trade Example

A Japanese Housewife borrows Yen 1000 from a bank at 1% and converts it to GBP.  She buys the GBP equivalent of Yen 1000 in UK Government Gilts that pay an interest of 4%.  The Housewife stands to make 3% per annum on this deal, all things being equal.  I hope you can see how this works with currency pairs?

Let's say a trader bought AUD/JPY a year ago.  There are a few possible outcomes on this trade.
  1. The AUD has fallen against The JPY.  Hopefully your stop loss has kicked in and your losses have been minimised, you've lost everything, or somewhere in between.
  2. The pair hasn't moved at all (A bit like the Japanese Housewife example above).  You will collect the interest rate differential on your position.  Note. Interest is paid on a daily basis.
  3. The AUD appreciates against JPY.  You pick up your profit plus The Carry.  The longer you are in your position the more interest you make.
To Sum Up

While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased. Your profit is the money you collect from the interest rate differential.  This is another way to make money in the forex market without having to buy low and sell high, which can be pretty tough to do day after day.

Remember this is a 'risk on' trade.  When economic conditions are uncertain, investors tend to put their investments in safe haven currencies, which tend to offer low interest rates like the U.S. dollar and the Japanese yen.

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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Introduction

When you buying a currency pair like AUD/USD you are buying the first currency (AUD) and selling the second currency (USD).  Basically The Carry Trade involves buying the currency with a high interest rate and selling the currency with a low interest rate - profiting from the interest rate differential.  

In effect you are sitting on a financial instrument with a higher interest rate than the one you sold.  The interest rate differential gained on a pair can be 3% or more.  When you introduce leverage, say of 10x leverage, that becomes 30%.  On 20x leverage, 3% becomes 60% - you get the idea?  This interest is added (or subtracted if you've bought the lower interest currency and sold the higher one - this is called the negative carry) from your position on a daily basis.

Important Considerations of The Carry Trade

The selection of the currency pair can make the difference between a losing and a profitable trade. When selecting the currency pair, traders want to observe the following: 
  • The trader wants to make sure he is buying the currency that has the higher interest rate and is selling the currency that has a lower interest rate in comparison.  
  • Understanding the role that interest rates play in the FX market is crucial. A country offering high interest rates will attract more capital as investors seek to capitalize on higher returns.  
  • The carry trade works best under 'risk on' trading environments and tends to break down under 'risk off' periods.  During 'risk off' periods traders fly to safe investments like the USD or JPY.  If the outlook of a country's economy looks as good, then chances are that that country's central bank will have to raise interest rates in order to control inflation - This is good for carry trade because a higher interest rate means a bigger interest rate differential.  On the other hand, if a country's economic prospects aren't looking too good, then nobody will be prepared to take on the currency if they think the central bank will have to lower interest rates to stimulate their economy - There's a flight to safety
  • The trader also wants to view the health of the economy for the currency pair to ensure the market will move to his/her favour.  Bond Spreads help here.  Technically we look for trending pairs.
  • Risk management rules still apply - you must always understand your potential losses.
  • This correlation is a long term strategy. Government policy takes time to implement, but nonetheless bond spreads can help to establish long run trend
  • Short term fluctuations in the market can create risk situations for traders.
Essentially, the trader will be buying a currency with a stronger economy and selling the currency with a weaker economy. the most commonly used currencies to fund carry trades are the Japanese yen and the Swiss franc because of their countries' exceptionally low interest rates. 

The popularity of the carry trade is one of the main reasons for the strength seen in pairs such as the Australian dollar and the Japanese yen (AUD/JPY), the Australian dollar and the U.S. dollar (AUD/USD), the New Zealand dollar and the U.S. dollar (NZD/USD), and the U.S. dollar and the Canadian dollar (USA/CAD).

The Simple Carry Trade Example

A Japanese Housewife borrows Yen 1000 from a bank at 1% and converts it to GBP.  She buys the GBP equivalent of Yen 1000 in UK Government Gilts that pay an interest of 4%.  The Housewife stands to make 3% per annum on this deal, all things being equal.  I hope you can see how this works with currency pairs?

Let's say a trader bought AUD/JPY a year ago.  There are a few possible outcomes on this trade.
  1. The AUD has fallen against The JPY.  Hopefully your stop loss has kicked in and your losses have been minimised, you've lost everything, or somewhere in between.
  2. The pair hasn't moved at all (A bit like the Japanese Housewife example above).  You will collect the interest rate differential on your position.  Note. Interest is paid on a daily basis.
  3. The AUD appreciates against JPY.  You pick up your profit plus The Carry.  The longer you are in your position the more interest you make.
To Sum Up

While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased. Your profit is the money you collect from the interest rate differential.  This is another way to make money in the forex market without having to buy low and sell high, which can be pretty tough to do day after day.

Remember this is a 'risk on' trade.  When economic conditions are uncertain, investors tend to put their investments in safe haven currencies, which tend to offer low interest rates like the U.S. dollar and the Japanese yen.

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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