One of the most popular investments in the financial markets today is the carry trade. This involves selling or borrowing an asset with a low-interest rate, with the aim of using the proceeds to fund the purchase of another asset with a higher interest rate.
By paying a low interest rate on one asset and collecting the higher interest earned by the other asset, you profit from the interest rate difference.
How Currency Carry Trading Works
When it comes to currency trading, a carry trade is one where a trader borrows one currency (for instance the USD), using it to buy another currency (such as the JPY).
While the trader pays a low interest rate on the borrowed/sold currency, they simultaneously collect higher interest rates on the currency that they bought. The interest rate differential between the two currencies is the profit.
Carry trading gives currency traders an alternative to “buying low and selling high” – a tough thing to do on a day to day basis. Most forex carry trading involves currency pairs such as the NZD/JPY and AUD/JPY due to the high-interest rate spreads involved.
Pros and Cons of Currency Carry Trading
Placing trades to take advantage of carry interest gives you an advantage since, in addition to trading gains, you also receive interest earnings. Carry trading also lets you make use of leverage to trade assets you would not otherwise be able to afford. The daily interest paid on the carry trade is based on the leveraged amount, which can make for huge profits from a relatively modest outlay.
Still, carry trading carries significant risk, specifically due to the uncertainty in exchange rates. The high levels of leverage utilised in carry trades mean that even small movements in exchange rates could result in large losses if a trader fails to hedge their position appropriately.
Due to these reasons, carry trading is only a good option for traders with a high-risk appetite. In any case, it should never be the main driver of your trades, but an additional aspect that gives you an advantage over the financial markets.
Risk Management in Carry Trading
There is no doubt that carry trading, while potentially lucrative, carries a fair amount of risk. This is because the best currencies for this type of trading tend to be some of the most volatile.
Negative market sentiment among traders in the currency market can have a rapid and heavy effect on “carry pair” currencies. Without adequate risk management, a trader’s account can be wiped out by an unexpected, brutal turn.
The best time to enter carry trades is when fundamentals and market sentiment support them. They are best entered at times of positive market sentiment when investors are in a buying mood.
Why might a carry trade end badly?
The problem with the carry trade is the uncertainty that comes with exchange rates. The rapidly changing forex exchange rates make it important for a trader to consider more than just the interest rate on a carry trade. The directional trend of the pair should also be taken into consideration since a move in the wrong direction can easily wipe out any profits made from the interest differential in the carry trade. That means a large loss can be realized even as the trader makes money on the interest rate difference.
Is the carry trade profitable?
There’s a theory that any interest rate differential should be offset by a corresponding change in the value of the currencies involved. So, in an efficient market the currency with the higher yield should depreciate to offset that higher yield. However historical data shows that this is not the case. In most carry trade situations, the higher yielding currency also appreciates versus the lower yielding currency, letting traders not only collect the yield differential, but also collect a return on the appreciation of the higher yielding currency.
What is the Yen carry trade?
The Yen carry trade, in which traders bought the U.S. dollar for its high yield while selling the almost yield-less Yen, was last in fashion in the earlier part of the 21st century, basically from 2004 to 2008. After the 2008 financial crisis U.S. interest rates dropped enough that the so-called Yen carry trade was no longer profitable. However, the Yen remains at zero interest rates and it is possible to participate in a Yen carry trade by buying the Australian dollar or New Zealand dollar while selling Yen. So in that respect the Yen carry trade remains alive.
Carry trading is a strategy that has the potential to be highly profitable over the long term if correctly managed. The steady stream of income it can provide can cushion you from the negative effects of exchange rate movements.
The Today Markets (New2Markets) education centre contains a host of articles that can guide you to understand the various trading strategies available for the money markets – including carry trades.
We also show you different ways to hedge your trades in order to mitigate and manage exchange rate risk. You can also put your carry trading skills to the test on our free demo account before you commit to investing real money. It is the best and most painless way to get your feet wet trading forex online in the international market.