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What is a carry trade?

ForexZig.com August 23, 2012
what is a carry trade

Carry trade

If you invest in stocks, bonds, commodities or currencies, you have probably heard about the so-called carry trade. This kind of strategy is very popular on the currency market. On this paper we are going to focus on the main points that each potential investor should know.

Carry trade is actually the purchase of currency with high interest rate, as in the same time you finance it with the sale of one with low interest. The basic idea is to gain from the interest differential between the both sides.

The most popular currency pairs, used for this type of transaction are Australian dollar / Japanese yen and New Zealand dollar / Japanese yen. This is so, because of the interest difference in the countries- for some it is low, for others – high.

The most essential thing about this strategy is the ability to accumulate interest. Particular Forex brokers charge interests in different way, most of them do this every day, but on Wednesday and at the weekends, the interests are threefold. Roughly speaking, this rate is the difference of the interest on the long position, minus that of the short one, multiplied by the size of the position, and respectively, it is divided by the number of the days in a year.

Of course, brokers do not use this formula on its pure form. The so-called swap numbers that you can find in their web-sites, are the interests, which are charted to individual positions. Usually they cut off a part of this price, which additionally brings to them profits, but decrease that of the carry trade investors.

From early 2000 to mid-2007, AUD/JPY brings an average profitability of 5.14%. On a first look, this is the interest that you would receive at the Bank, but on a market that offers leverage of 100 to 1, this will change the situation significantly. Of, course it would be a suicide to trade in such proportion, but even at 5 or 10 times the investment could bring good profit.

At the same time, the currency itself, which is an object of  carry trade, becomes significantly more expensive, also bringing capital gains. For example, during the last few years AUD/JPY increased nearly two times, and adding the interest and using the leverage made the profit from carry trade considerable.

Of course, things are not so easy, opening a position always carry its risks. The strategy would be unsuccessful if the currency was devalued by more than average interest income. If you use leverage, the loss could be severe. So in bad circumstances, it could be seen very volatile movements in currency pair, if large positions are liquidated.

Carry trade works when the Central banks increase the interests, or just plan to do this. Nowadays, currency trading is extremely easy of access, using the Internet.  The carry trade charm is not only for the interest, but also for the capital gains that it could bring. The point is to get into a cycle of increasing interest at the beginning, not at the end. Of course, when sooner or later, countries with higher interest rates begin to cut it off, this will question the profitability of the deal. This initial change of policy is a basic change in the trend of currency.

When the interest goes down, the foreign investors probably search for other options to gain profit. This will decrease the demand for currency, which in turn will provoke sales.

Probably, most suitable for carry trade is to use a couple of currency pairs, which limits the risks. The funds allocation can be done by opening smaller positions in different pairs.

Carry trade is a long-term strategy, which is more appropriate for investors, than for speculators. Sometimes these positions could be held for months or even for years.

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