Everything You Need to Know About Currency Carry Trade

What is Carry Trade?

Carry trade is a trading strategy where you borrow money in a monetary zone with a low interest rate with the intention of depositing the funds in another monetary zone with a higher interest rate.

A simple example of carry trade

In a hypothetical situation, an investor borrows 100,000 Swiss francs (CHF) at an interest rate of 1.5% per annum and converts them into US dollars (USD) at an exchange rate of 1.12%. This yields 112,000 USD, which they decide to invest in a bond paying 5% per annum. 

At the end of the year, the bond sells for 117,600 USD, a profit of 5,600 USD, and 5% of the investment in USD. Since the exchange rate did not change, the 5,600 USD is worth 5,000 CHF, but the investor must also pay 1.5% interest on the loan, which amounts to 1,500 CHF. 

Assuming the exchange rate did not change, the return on the investment is 3,500 CHF (5,000 – 1,500) or 3.5%, which corresponds to the interest rate differential (5% – 1.5% = 3.5%) 

Of course, this is a simplified example because one would have to subtract the applicable transaction fees to calculate the actual net return.

How the Currency Carry Trade Strategy Works

A carry trade transaction on the foreign exchange market implies that a trader opens and closes their trading positions on the currency pair mainly in order to profit on the interest rate differential between the two monetary zones.

Why is the foreign exchange market ideal for carry trade transactions?

On the FOREX market, traders always trade currency pairs.

If they anticipate the currency pair’s value will rise, they will open a buy position on the pair in question. 

This means they will buy the base currency (the first currency in a FOREX pair) and automatically sell the quote or counterparty currency (the second currency in a FOREX pair). The opposite happens if traders expect the exchange rate to drop due to short selling.

This aspect of simultaneous buying and selling of two currencies to profit from swings in the value of a currency pair makes carry trade transactions on the FOREX market possible.

Positive currency carry trade vs. negative currency carry trade

Generally, positive currency carry trade on a currency pair is the most popular.

In this case, a trader will borrow money at a relatively low policy interest rate, such as a funding currency, to buy a currency with a higher interest rate, such as an investment currency or carry currency.

The trader’s strategy, in this instance, is to receive the rate differential between the two currencies.

But there is an opposite strategy called negative currency carry trade (or reverse currency carry trade). In this situation, the trader will borrow a high-interest-rate currency to finance the purchase of a low-interest-rate currency.

The goal is to take advantage of this currency pair’s possible downward trend to compensate for the losses generated by the interest rate differential.

A positive carry trade transaction typically generates an initial gain, offset by a potential risk of loss. In contrast, a negative carry trade transaction begins with an initial loss offset by the potential for profit.

The Importance of the Interest Rate Differential in this Strategy

The interest rate differential between two currencies is a key concept behind the currency carry trade strategy. Without a difference in the interest rates between two monetary zones, it would indeed be impossible to take advantage of such a strategy.

Suppose the interest rate differential between two currencies is significant. In that case, the carry trade strategy is more profitable for the trader because they will receive more interest than they have to pay.

Therefore, traders will generally focus on currency pairs whose interest rate differential is substantial, meaning this technique will bring greater profits.

To familiarize yourself with the interest rate trends of various currencies, you should follow the central banks’ decisions on their key interest rates. 

The central banks of each country meet several times a year to decide whether to vary the course of their monetary policies based on the level of inflation and economic growth.

The deposit interest or interest expense reflected in the balance of your trading account does not directly take into account the key interest rate but rather the overnight money market or interbank rate, including fees added by financial intermediaries.

Do not ignore the directional trend of the pair.

Even if the carry trade strategy is based primarily on the interest rate differential between two monetary zones rather than on shifts in the exchange rate, do not underestimate the directional trend of the currency pair in question. Doing so could be detrimental.

Suppose you are focusing on a carry trade transaction on a currency pair in a downward trend. The losses associated with this downward movement could cancel out the gains you might make using your currency carry trade strategy.

Which Currency Pairs Should You Choose to Make a Currency Carry Trade Today?

Today, the developed economies with the lowest interest rates are Japan (-0.10%) and Switzerland (1.5%).

On the other hand, Europe (3.5%), New Zealand (5.25%), Australia (3.85%), the United Kingdom (4.25%), Canada (4.50 %), and the United States (5 %) have the highest interest rates.

Accordingly, and in light of their rate differentials, the USD/JPY, AUD/JPY, NZD/JPY, as well as the GBP/JPY currency pairs, initially seem to be attractive prospects for carry trade transactions.

The USD/JPY pair: Overall winner of the currency carry trade strategy during the 2000s

The USD/JPY currency pair figures prominently among historical examples involving the carry trade strategy.

After the Asian financial crisis, the Bank of Japan (BOJ) was the first to lower its interest rates to 0%, whereas the interest rate in the United States was 4.75%. 

Shortly thereafter, the BOJ introduced a quantitative easing program and intervened in the foreign exchange market, diminishing the value of the Japanese yen.

So, investors borrowed Japanese yen at low interest rates and invested the funds in stocks at a higher rate of return using US dollars.

This activity generated greater demand for the US dollar, thus increasing the value of the USD/JPY currency pair. 

This strategy led to significant profits due to the interest rate differential between the two currencies.

However, the 2008 global financial crisis caused a considerable decline in the global financial markets, which in turn caused the Japanese yen to appreciate sharply because it was considered a safe-haven currency. Furthermore, the United States substantially lowered its key interest rates, which impacted the US dollar.

The Advantages and Disadvantages of Using Carry Trading

Why would you incorporate a currency carry trade strategy in your trading?

Here are the main advantages of using carry trade transactions in your trading 

• Potential profit from changes in the value of the currency pairs in addition to the interest rate differential. The carry trade strategy focuses mainly on the interest rate differential between two currencies to turn a profit. But one can also profit from the rate difference in the currency pair being traded.
  
• Potential profit due to leverage. The currency carry trade strategy is often used with margin trading and leverage, which could potentially increase profits.

• Option of diversifying your portfolio, gaining exposure to the currency market, and potentially increasing profits. You could also use carry trade to diversify your portfolio by investing in currencies with different interest rates, reducing your overall risk. In addition, profits from one transaction could offset losses from another which could help mitigate overall potential losses.
  
• A time horizon that does not require constant monitoring of positions. Generally, the medium-term time horizon associated with the carry trade technique frees you from the need to be glued to your computer screen, constantly monitoring your positions.
  
• Relatively low transaction fees. Compared to other markets, the FOREX offers competitive fees. Since the currency carry trade strategy does not trigger much movement, the associated trading fees are minimal, especially compared to the trading fees for scalping or day trading.

What are the risks associated with the currency carry trade strategy?

A currency carry trade transaction is not without risk:

• Increase in potential losses due to leverage. Using leverage in a currency carry trade transaction can lead to a considerable loss. Leverage in the stock market magnifies all price movements. The greater the leverage, the greater the potential losses.
  
• Abrupt change in monetary policy. It is entirely possible that a central bank suddenly decides to take steps to support its economy or avoid overheating. If the markets have not foreseen a significant increase or reduction in interest rates, the advisability of a carry trade strategy could change drastically. In addition, there could be serious movement in the value of the currency pairs in question, which could also impact the profitability of the carry trade strategy.
  
• Unpredictable swings and volatility in currency pair values. Unforeseeable events, such as wars or natural disasters, cause some movements. Exchange rate shifts in FOREX pairs can affect the profitability of carry trade strategies.

The Best Tips for Conducting Currency Carry Trade

Let’s finish this article with a few tips to help you improve your currency carry trade strategy.

Focus on pairs with a substantial interest rate differential to maximize your profit potential. However, do not ignore the directional trend or the volatility of the pair. 

For example, use technical analysis and graphs to improve your decision-making.

Even if leverage helps you increase your profit potential through greater market exposure, it is essential to know how to control it because it also increases your risk of loss.

You need to understand what leverage is and how it influences your trading in order to predict how it will impact your carry trade strategy.

To limit your risk of loss, you should limit the level of leverage you use. You should also follow a strict money management strategy.

Finally, it is important to monitor changes in several economic indicators that will help you predict developments and trends in interest rates.

The best time to execute a carry trade is either when interest rates are high or during a period of low volatility. However, traders seem inclined more toward risk. 

On the other hand, low interest rate periods are not profitable for traders. The reasons are two-fold. First, the interest rate differential can fall, and second, demand for the particular currency can also fall, causing a reduction in the value of the currency pair.

Because of the unpredictability of certain factors that strongly influence a country’s monetary policy or the value of currency pairs, most traders prefer short- or medium-term carry trade strategies rather than long-term strategies.