over a period of time? The spot forex market offers just that opportunity. The Carry
Trade Strategy is a popular way of trading the global forex market, and is a strategy
highly favoured by large financial institutions such as hedge funds, pension funds
and banks. What makes carry trades so desirable is the possibility of earning
interest, which is a unique aspect that traders – both big and small alike – can take
advantage of.
All currencies in the world have interest rates attached to them, and these rates are
decided by each country’s central bank. For example, the Federal Reserve Bank in
the US determines the country’s interest rates while the Bank of England sets the
United Kingdom’s interest rates. Since each country sets its own interest rate,
countries – or, rather, their currencies – are bound to have varying interest rates.
Some countries may have relatively higher interest rates while others may have
relatively lower rates. How can traders exploit the fact that some currencies have
much higher interest rates than others? Let me introduce you to the concept of a
carry trade.
What Is A Carry Trade?
A carry trade is a long-term fundamental trading strategy that involves the selling
of a certain currency with a relatively low interest rate, and using the funds to buy
a currency which gives a higher interest rate, with the hope that the high-interestrate
currency will appreciate against the low-interest-rate-currency. When these
positions are held overnight, carry traders are paid interest on the currency they are
long in, and must pay interest on the currency they are shorting. The interesting
aspect of this strategy is that the investor or trader is able to gain the difference
between these two interest rates, known as the interest rate differential or spread,
which can be a hefty amount when leveraged.
A Basic Carry Trade Strategy
1. Buy a currency with a high interest rate, and
2. Sell a currency with a low interest rate
Currencies and interest rates
• Currencies with typically high interest rates: GBP, NZD, AUD, CAD
• Currencies with typically low interest rates: JPY, CHF
The Japanese yen and the Swiss franc tend to be on the selling side of the carry
trade due to their traditionally low interest rates. Such low-interest-rate currencies
are known as funding currencies since they are used to fund the purchase of high
interest rate currencies such as the British pound, the New Zealand dollar or the
Australian dollar which tend to have high interest rates.
Example: carry trade
Here is an example of a carry trade. Let’s say the Japanese yen has
an interest rate of 0.25%, and the New Zealand dollar gives an
interest rate of 7.25%. Since the New Zealand dollar has a higher
interest rate than the Japanese yen, a trader who wishes to profit
from a carry trade may buy the New Zealand dollar and sell the
Japanese yen at the same time. An annualised profit of around 7%
(7.25% - 0.25%) may be reaped from the carry trade if no leverage is
used. This return is based on the assumption that the exchange rate
between the New Zealand dollar and Japanese yen remains
unchanged throughout the holding period of one year. If that carry
trade is carried out with a 10 times leverage, it will increase the
unleveraged 7% annualised return to a huge 70% annualised return.
The conventional notation of currency pairs is such that JPY and
CHF tend to be the counter currency while GBP, NZD and AUD tend
to be the base currency in a currency pair. Hence, traders who are
interested in carry trades will long currency pairs like GBP/JPY,
AUD/JPY or NZD/CHF, effectively buying the first currency in each
pair (which also tends to be the higher-yielding currency) and
simultaneously selling the second currency in the pair (which tends
to be the lower-yielding currency). Since they are trading these
currency pairs in the long direction, they will want the base or highyielding
currencies to strengthen in value against the counter or lowyielding
currencies.
Source: 7 Winning Strategies for Trading Forex: Real and Actionable Techniques for Profiting from the Currency Markets
