The carry trade is one of the most popular strategies in forex trading because it guarantees some type return on medium or long term positions. In a carry trade, the trader or speculator is attempting to not only gain from the rise or decline of the currency pair, but also the interest rate differential between the two currencies.
When carry trading, the trader buys (or goes long) the currency with the higher interest yield while selling (or going short) the currency with the lower interest. The speculator is attempting to capture the interest rate differential as well as any appreciation in the currency. The carry trader is often more interested in the positive interest earned on the currency pair rather than the profits from the trade itself.
Let’s take a look at a sample carry trade:
1. Trader Buys New Zealand Dollars (Earns 6.5%)
2. At the same time, Trader Sells Japanese Yen (Pays 0.30%)
3. If the currency pairs stays at the same rate for the whole year, trader makes 6.15% (Interest Rate Difference)
If this is a 100k position, the trader has earned 6.15% interest on 100,000. With 10:1 leverage, the trader put up 10k and earned $6,150 NZD.
The New Zealand/Japanese Yen currency pair has been a great example of this strategy in the recent past. Forex traders bought the pair not for economic growth in the New Zealand economy, but the carry trade opportunity. Currency traders jumped at the chance to earn the 8 percent interest rate that the Reserve Bank of New Zealand was offering at the time while simultaneously, paying a cost of 0.5 percent for the Japanese Yen.
This 7.5% rate on margined funds lead to huge potential gain and this decision helped money managers garner a high return on a rise in the currency as the New Zealand dollar appreciated against the Yen while also gaining from the wide difference in interest rates between the countries.
What to Look For in a Carry Trade
1. Large interest rate differentials:
The New Zealand dollar and Japanese Yen example was used earlier due to the more than 6% interest rate differential
2. Low Market Volatility
Volatility is the enemy of the carry trade. When there is long term market turmoil, the carry trade may not be an effective straetgy
3. Healthy Economy
As a generalization, the country with the higher interest rate should attract more foreign investments as investors look for a higher return. This wouldn’t be the case of a country like Zimbabwe where the interest rate is 8500%, but with inflation at over 231,150,000% this would be a very risky investment.
If you follow these guidelines the carry trade can be a very good forex trading strategy to know.
By: Richard C. Lee