Carry trade strategy guidelines (PDF)
In general, a carry trade strategy is a financial system whereby investors seek to profit from the interest rate differential between two assets. Known as ” currency carry trade “, this technique stands as one of the most used strategies in the Forex market. In effect, it relies on the simple method of generating profits from paying and receiving different interest rates on a currency pair. So, in order to well understand this strategy, we will provide you with a comprehensive carry trade definition and outline a practical carry trade example.
What is carry trade strategy?A carry trade strategy is one of the most straightforward techniques for trading that exists in the financial markets. In fact, it is a strategy that applies to borrowing or selling from a low-interest rate financial asset and then purchasing an asset that provides a higher interest rate. Hence, the trader will generate profits from buying and selling assets with different interest rates. To explain more, using this strategy means that, in a way, we will pay interest on the financial instrument that we sold. (the one with the low-interest rate). On the other way, we will collect interest on the instrument that delivers a rate. As a result, we will make earnings from the interest rate differential.
So, as long as the trader holds that kind of trade, in which the interest moves in a positive direction, it will be paid by the broker. Otherwise, the trader can carry losses, if the favorable interest turns to a negative one.
Usually, the carry trade strategy is used in the Forex market. Thus, a currency carry trade occurs when the currencies in the Forex pair have an uneven interest rate. In which, one currency will have a higher interest rate than the other. Thereby, depending on the volatility of the exchange rates, Forex traders will try to create some profitable opportunities. By receiving a positive interest differential from the broker.
Actually, while we use such a strategy we will obtain interest gains besides the trading earnings. Regardless, a carry trade strategy permits traders to use leverage to their benefit in order to amplify the interest paid by the broker. However, we should conduct a carry trade strategy with caution to avoid heavy effects.
How does carry trade strategy works?
In order to comprehend how the carry trade operates, we should first see how we can use the same concept in reality. So, let’s illustrate a generic example to understand how the carry trade strategy works. For this reason, we will consider “Mister A” who borrows from the bank 100.000 $. Consequently, for lending this amount, he should pay yearly 1% of the 100.000 $ as fees.
Nevertheless, after taking the money, “Mister A” decides to purchase a bond that costs 100.000$ and guarantees a 5% yield per year. So, after a year, “Mister A” will gain 5% in interest from the bond (5% of the 100.000 $ as a profit). On the other side, he will pay 1% in interest to the bank. As a final result, “Mister A” will earn 4% of the 100.000 $. It is the difference between interest rates of 5% and 1%.
Regardless, applying this approach in the Forex market can be more attractive and profitable. In effect, due to the high leverage levels offered by different brokers and the daily interest payments, Forex traders can make much more profits than the carry trade example above. So now let’s try to adjust the previous example to a simple currency carry trade.
Actually, in the forex market, we trade currencies in pairs. That means if we purchase the pair “X/Y”, we will automatically buy the currency “X” and sell the currency “Y” at the same time. Accordingly, this involves that we pay interest on “Y” (the currency that we sold), and receive interest on “X” (the currency that we bought), every trading day, as long as we hold the position. This process used by brokers of debiting and crediting the account each day by the interest rate differential represents the cost of “carrying” trade to the following day. However, what really makes the carry trade strategy popular and interesting, is the fact of using high leverage. So, with an account that uses a 50:1 leverage ratio, the 4% interest rate differential (previous example) becomes 200%.
Carry trade trading example
As we already discussed, the carry trade strategy is often used in the Forex market. Especially with the cross-currency pairs. Nonetheless, the currency carry trade is margin-based. Where we can put up small amounts to open important positions using different leverages available from brokers. In the Fx market, most brokers require between 1% to 5% of a position, which really seems attractive for traders.
Yet, in this carry trade example, we will pass through all the possibilities that can happen while using this strategy. So, we will assume that “Mister B” opens a real trading account. Then, he makes a deposit of 5000 $.
After analyzing the Forex market, he finds that the AUD/JPY currency pair has an important interest rate differential (more than 4% a year). Hence, he decides to purchase 100.000 $ worth of that Fx pair. However, since “Mister B” uses a 100:1 leverage, his broker needs a 1% deposit of the position. That means, holding 1000 $ as a “margin”.
At this point, “Mister B” will control 100.000 $ worth of AUD/JPY which generates 4% a year in interest. Thus, he plans to keep and maintain the same trade for a year, without doing anything. Hoping that the interest rate differential remains stable.
So after a year of making the investment, “Mister B” can find himself in three different situations:
- The AUD/JPY pair loses value:
If the AUD/JPY drops in value, that means the market is moving against “Mister B”. Consequently, he will bear losses and may face the risk of a “margin call” which will bring the account bankrupt. As a result, all that will be left for “Mister B” is the “margin” (1000 $).
- The AUD/JPY pair keeps the same value:
If the AUD/JPY ends up maintaining the same exchange rate without gaining or losing value, then, “Mister B” will receive from his 100.000 $ position, a 4% in interest. That equals 4000 $. Which represents an 80% gain on his 5000 $ account. At this juncture, we can notice the important impact of 100:1 leverage, which allows “Mister B” to gain 80% a year from his initial investment (5000 $).
- The AUD/JPY pair gains value:
In this case, “Mister B” will collect more than he expects, and his total gains will exceed 4000 $ in interest on his position.
Indeed, we should be aware when choosing the Forex pair before applying a currency carry trade strategy. Because the currency pairs that suit this trading system tend to be volatile. Wherefore we must set proper forex risk management when dealing with these “carry Pairs”.
In brief, as we mention in the carry trade definition, this trading system could be risky if the positive interest differential of the financial instrument turns to a negative carry trade rate. Thereby, like all Forex strategies, nothing is guaranteed, and the market could move against you anytime. That is why it is important to monitor and control our position when requires.