Carry Trade Strategy Ideas

Is it possible to earn some passive income while you hold certain currency positions
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

Carry trade strategies basic

A carry trade happens when you buy a high-yielding currency and sell a relatively lower-yielding currency. The strategy profits in two ways:

• By being long the higher-yielding currency and short the lower-yielding currency, you can earn the interestrate differential between the two currencies, known as the carry. If you have the opposite position — long the low-yielder and short the high-yielder — the interest-rate differential is against you, and it is known as the cost of carry.
• Spot prices appreciate in the direction of the interestrate differential. Currency pairs with significant interestrate differentials tend to move in favor of the higheryielding currency as traders who are long the high yielder are rewarded, increasing buying interest, and traders who are short the high yielder are penalized, reducing selling interest.

So let me get this straight, you may be thinking: All I have to do is buy the higher-yielding currency/sell the lower-yielding currency, sit back, earn the carry, and watch the spot price move higher? What’s the catch?

The catch is that downside spot price volatility can quickly swamp any gains from the carry trade’s interest-rate differential. The risk can be compounded by excessive market positioning in favor of the carry trade, meaning a carry trade has become so popular that everyone gets in on it.

Carry trades usually work best in low-volatility environments, meaning when financial markets are relatively stable and investors are forced to chase yield. Keep in mind that carry trades need to have a significant interest-rate differential between the two currencies (typically more than 2 percent) to make them attractive. And carry trades are definitely a longterm strategy, because depending on when you get in, you may get caught in a downdraft that could take several days or weeks to unwind before the trade becomes profitable again.
For Dummy : Carry trade strategies basic

Risks Involved In Carry Trade

The biggest risk in the Carry Trade Strategy is the uncertainty of future exchange
rate fluctuations.
For a carry trade to work, the high-yielding currency must rise, or at the very least
remain steady, against the low-yielding one over a period of time.Adepreciation of
the high-yielding currency can cause carry traders to lose money, as they are betting
on an unchanged or a rising exchange rate of the currency pair, and this decline can
even erase any gains earned from the interest.

For example, if you go long on a currency pair like NZD/JPY as a carry trade, you
expect and want the New Zealand dollar to appreciate in value or at least remain
unchanged versus the Japanese yen for however long you intend to hold your
position for. If NZD/JPY goes up, you will stand to gain not just from the interest
spread, but also from capital appreciation. The risk then is for the carry trade pair
to decline more in percentage than what you would gain from the interest fees.

You must understand the fundamentals
If you are thinking of employing the Carry Trade Strategy, you must first
understand the fundamental factors that are supportive of carry trades, and be
confident that the high-yielding currency will continue to rise or stay unchanged
against the low-yielding currency over a period of time. Should market sentiment
reverse and change due to economic, monetary or political conditions, carry traders
may decide to liquidate their long positions (by selling), perceiving that the highyielding
currency would drop in value, and thus harm their long trades. This
unwinding can come about quickly and without much warning, and can usually last
for quite some time (months or even years) especially if overall perception towards
the currencies in the carry pair is changed drastically based on major fundamental
changes. Another reason for the possible prolonged unwinding of carry trades is
that not all carry trades will unwind at the same time.

NZD/JPY cross
For example, in 2005, the NZD/JPY cross was one of the more popular currency
pairs to carry trade as it offered a wide interest rate spread. At that time, with New
Zealand’s interest rates standing at 7.25% and Japan’s interest rates remaining at
0%, a trader buying the NZD/JPY could make 725 basis points from yield alone. If
a 10 times leverage had been applied to this carry trade, it would have yielded a
72.5% annual return from the rate gap alone, and that was in addition to capital
appreciation of the pair itself.

Anyway, NZD/JPY was in an overall uptrend in 2005, which was good news for
carry traders as they not only made on the substantial interest spread (if leveraged),
they also gained from the rising strength of NZD/JPY. However, near the end of

2005, things started to turn sour for carry traders. There were market rumblings
about the possibility of Japan discarding the Zero Interest Rate Policy, and
investors worldwide feared that the Japanese central bank was going to raise
interest rates sometime in 2006. That resulted in a six-month decline of NZD/JPY
as carry traders and investors closed their longs.


NZD/JPY was not the only currency pair to suffer the consequences of carry trade
unwinding. USD/JPY, being another hugely popular carry trade pair, also
experienced a severe and sharp decline from December 2005 till May 2006, when
the Bank of Japan hinted at raising interest rates in Japan.
Source: 7 Winning Strategies for Trading Forex: Real and Actionable Techniques for Profiting from the Currency Markets

Factors Supportive Of Carry Trades

Good economic and political conditions of the high-yielding currency
When it comes to deciding where to invest their money, investors will not only
assess the rate of return, but also the economic conditions and political stability of
the country which holds the assets. Generally speaking, developed countries that
offer relatively high interest rates are those which tend to experience decent
economic growth and expansion, which may in turn attract more foreign
investment into their country. An economy that is doing reasonably well will more
likely be able to pay high interest rates to investors. However, it is not just the more
developed countries that may offer high interest rates; many emerging economies
may do so as well, simply because they tend to experience higher inflation. These
are generally not countries where most investors will park their money due to the
high level of economic instability.

Political stability is also another aspect that investors are concerned with because a
politically stable country will provide a good framework for trade and investment.
Adverse economic and/or political conditions could have a negative impact on
foreign investment in the country, and may cause investors to move their assets out
and convert the high-yielding currency into their local currencies, thus resulting in
depreciation in exchange rates of the carry pair.

Widening interest rate gap
The wider the difference in interest rates between the two currencies in a pair, the
higher the interest that will be paid to traders who long the carry pair (with the highyielding
currency as the first currency in the pair) over a period of time. And the
higher the interest fees that will be paid, the more it will attract other traders or
investors to enter carry trades, thereby potentially pushing up the value of the highyielding
currency further as demand for it increases.

On the other hand, a narrowing interest rate gap between the two currencies will
cause traders and investors to lose interest in holding their carry trades and
discourage more people from joining in the carry trades as the interest fees paid out
will decrease. Such a scenario can occur when interest rate hikes are expected to
take place in the country of the low-yielding currency, thereby lifting the currency
from the current low interest rate, or when interest rates are expected to be cut in
the country of the high-yielding currency.

So as a rule of thumb, the wider the interest rate gap exists between the two
currencies, the higher the likelihood of a profitable long-term carry trade.
Source: 7 Winning Strategies for Trading Forex: Real and Actionable Techniques for Profiting from the Currency Markets