Carry Trading

Introduction: What is a Carry Trade?

A carry trade is a trading strategy where a trader sells a particular currency which has a relatively low-interest rate and makes use of the funds to buy a different currency that yields a higher interest rate. The aim is to profit from the differentials in the profits earned from the long trade on the higher yielding currency and the short trade on the lower yielding currency. With carry trading, traders can profit substantially if the price stayed the same for long periods.

The Carry Trade

As explained above, a carry trade entails selling or borrowing a financial asset with a low-interest rate and then using the money made from its sale to buy a financial asset that has a higher interest rate. For instance, a trader could short a currency with a 1% interest, and invest in the purchase of a different currency with 5% interest rate. Therefore, a trader’s profit is the money they collect from the interest rate differential. Carry traders depend on stable prices and stable exchange rates to capture the difference between the rates. The amount realized can be quite huge, depending on the amount of leverage a trader uses. Carry trade transactions usually involve a lot of leverage, as such, a small change in currency exchange rates can lead to massive losses unless a trader hedges their position appropriately.

The practice of the carry trade in forex dates back to the 1990s when the strategy became popular. Forex traders, particularly those at hedge funds, started seeing opportunities in large interest rate differentials between big economies like Japan (lower interest rates) on one side, and the US/Australia/New Zealand (higher interests) on the other side. At that time, interest rates in the US were about 5%, while rates in Japan were at near-zero levels. Investors could borrow capital in a low interest environment (e.g. Japan) and plough into a high interest environment (such as Australia, were interest rates got to as high as 8.25% in 2007), thus allowing a good profit from the interest rate differentials.

In the period leading up to 2007, many traders borrowed in lower-yielding currencies and invested heavily in higher yielding currencies (USD, ZAR, AUD and NZD). Carry trades were thus setup in the GBPJPY, AUDJPY, NZDJPY, etc. These carry trades held sway until the global financial crisis forced central banks across the world to cut interest rates in order to stimulate borrowing and consumer spending as a means of getting out of the waves of recession that swept world economies.

What are the Best Currency Pairs for Carry Trade in the Present Day?

With the carry trade strategy becoming increasingly popular in recent times, traders are taking to carry trading in large numbers. The problem facing them, however, is that with most economies doing their utmost to outdo each other, global interest rate differentials are becoming narrower, as currencies continue to rally against each other. That notwithstanding, we have identified some of the currency pair trades that have the highest interest rate differentials in the present day.

But before we proceed, it is important to explain the mechanics of carry trade in the currency markets today. For instance, when we enter into a USD/CAD trade, we are in effect, buying the US Dollar and selling the Canadian Dollar. This is done at a fixed contract size and at the going exchange rate. When we purchase the above pair, it is expected that we would want the price of the US Dollar to rise in comparison to that of the Canadian Dollar. But at a more technical level, we are borrowing the CAD to fund our purchase of the USD.

With that being said, some of the most in-demand currency pairs for carry trade in the present day include the AUDJPY, USDJPY, NZDJPY. Others include the NZD/EUR, EURAUD, GBPAUD, NZDCHF AUDJPY, and the NZD/USD. These currency pairs comprise of those from some of the most stable economies with the most attractive interest rate differentials in the world today.

How to Select Currency Pairs for Carry Trade

When it comes to choosing the currency pairs for carry trade, one of the things you need to consider is the interest rate spreads. Usually, the right currency pairs to select for a carry trade is that which has a very high-interest rate spread. As such, the first step you should take is to try to identify the currency that provides a high yield and the one that offers a low yield. The goal is to mix-match the currencies with the maximum and minimum yields, considering their interest rate.

As of September 2017, the interest rates for some of the most liquid currencies in the world include:

Currency – Interest Rates

  • Australian Dollar (AUD) = 1.500%
  • US Dollar (USD) = 1.250%
  • Euro (EUR) = 0.000%
  • UK (GBP) = 0.250%
  • Japanese Yen (JPY) = -0.100%
  • Canadian Dollar (CAD) = 1.000%
  • New Zealand Dollar = 1.750%
  • Swiss Franc (CHF) = 0.750
  • Source: www.global-rates.com

On account of this, traders who wish to invest in currency carry trade would fare better by investing in forex pairs such as the NZD/JPY, EURNZD, EURAUD, GBPAUD, NZDCHF, etc.

Advantages of the Carry Trade

Carry trade is a beneficial strategy of investment that generates substantial profits for traders in times of global financial stability. Traders can use this approach to benefit in ways that include:

  • Carry trading is financially rewarding. Carry trade generates significant profits for traders, especially in periods of exchange rate stability.
  • Carry trade is flexible. It enables traders to devise different means of managing downside risks.
  • Carry trade does not involve too many complications.
  • Traders can hold a position for an extended timeframe to enable them to take advantage of interest rate differentials. This makes it possible for them to maximize profits.

Conclusion

Carry trading is a beneficial venture for forex traders. By engaging in carry trades, traders would collect a premium payment on a regular basis. However, knowing the ins and outs of the strategy is important if one must profit on a consistent basis. And as already mentioned, with carry trade, interest rates dictate the rate of return for holding assets denominated in a particular currency. So you would do well to stay up-to-date with the economic and other market-moving news, as knowing the going rates will help you to avoid some pitfalls that may result due to a lack of information.