Carry Trade Strategy

Currency Carry Trade Strategy

In general, carry trade means borrowing money at a low interest rate and investing in assets with higher returns.

 

Currency Carry Trade

Currency Carry Trade is a strategy that involves selling a currency offering a relatively low-interest rate and at the same time buying a currency offering a relative high-interest rate. The goal of Forex carry traders is to capture the interest rate differential between two currencies which can be substantial, depending on the rate of capital leverage they use.

Usually, currency investors are borrowing money in Japanese yen or Swiss francs which are two currencies offering traditionally very low-interest rates, close to zero. They use this money they borrowed for opening long positions in currencies backed by high-interest rates, such as the Canadian Dollar, the New Zealand Dollar and the Australian Dollar.

 

About Interest Rates

Interest rates affect the Foreign Exchange market in an extreme degree. Any interest rate change applied by one of the eight major global central banks can turn the Forex market upside down. Surprise rate changes have an even bigger impact on the market.

Interest rate change according to new economic conditions and every interest rate policy aims to stabilize the economy. The interest rate policies have two main missions, to enforce growth or to reduce inflation:

(i) Interest Rates Decrease aims to Increase Growth and to Lower Unemployment

(ii) Interest Rates Increase aims to Lower Inflation

As you can see in the following table, major central banks apply different interest rate policies. This is because monetary authorities have different goals and every economy in the world has its own unique characteristics. Japan and Switzerland are offering traditionally low-interest rates.

World's Major Central Banks and their Interest Rate Policies
Reserve Bank of Australia	2.00%
US Federal Reserve	0.50%
Swiss National Bank	-0.75%
European Central Bank	0.05%
Bank of Japan	-0.10%
Reserve Bank of New Zealand	2.50%
Bank of Canada	0.50%
Bank of England	0.50%

Interest Rate Trends

Interest rates move in trends and that is because the economy moves in cycles and it also trends upwards and then backward.

Compare Forex Brokers and their Policies: Forex Brokers List

 

Currency Carry Trade Strategy

A carry trade strategy involves selling a low-interest-rate currency and buying a high-interest-rate currency. Carry trade is one of the most successful Forex trading strategies.

The Overnight Rate

Carry traders are paid an interest rate differential each and every day of the year exactly at midnight (according to the time server of your broker).

This interest rate differential is called a Rollover Rate or Overnight Rate or Swap Rate. On Wednesday, this Overnight Rate is tripled (x3) in order to cover the missed rates of Saturday and Sunday.

Popular Carry Trade Forex Pairs

The New Zealand Dollar and Australian Dollar offer the highest interest rate yields and the Japanese Yen and Swiss Franc the lowest interest rate yields. That is why Forex pairs such as AUD/JPY or NZD/JPY are some of the most traded pairs by Forex carry traders.

The Japanese Yen and its Correlation with US Stocks

The Japanese Yen has traditionally being used as a borrowing currency by equity traders around the world. These traders borrow money in Japanese Yen which offers close to zero interest rates and buy US stocks that are moving in long-term bullish trends or stocks that offer very high dividend yields. This practice has created a strong correlation between the JPY market and the stock-market. In the following USDJPY chart and Dow Jones chart, you can see that Intermarket correlation in an extreme example of identical trading.

Chart: USDJPY and Dow Jones Correlation in early 2016

Calculate Interest Rate Earnings

The daily interest for each and every Forex currency is calculated as follows:

■ (Interest Rate of the Long Currency  – Interest Rate of the Short Currency) X Position Size

Example

For a long position of NZD/USD of 5 standard lots here is the computation of daily earnings:

■ (.0250 – 0.005) x 100,000 x 5 = 10,000 USD / 365

Approximately that means $27.37 a day

Note that brokers may use slightly different overnight rates.

 

Important Factors Affecting Currency Carry Trade

Here are some key points for successful Currency Carry Trade:

(1) Leverage Wisely Your Positions

In the previous example of Carry Trade in AUDUSD, we saw that a long position of 500,000 USD (5 lots) can generate about 10,000 USD annually. Carry traders can open 5 lots with an account worth only 5,000 USD and that means leverage 100:1. In that case, if everything works favorably Carry Trade can achieve 200% returns in a single year. The problem with this picture is the risk taken. If you open a position worth 5 lots by holding on margin only $5,000 you are exposed in an enormous risk that will probably lead your account to zero. Therefore, successful Carry Trade means not to be greed and leverage your funds from 2:1, 5:1 and up to 10:1. That means considerably lower returns but also considerably lower risk.

(2) Interest Rates Forecast

If certain central banks are planning to increase their domestic-currency interest rates this may be a wonderful chance for Carry Trade. Money tends to flow where the yields are higher and the motive for Carry Trade is not limited to the interest rate differential but also the potential capital appreciation. Therefore, before deciding to open any carry trade positions research a lot the expected interest rate policies of the two central banks involved.

(3) The Volatility Factor

In general, the carry trade strategy will perform better in a low-volatility environment. Carry traders feel more comfortable when their investment is exposed to low-risk. High volatility in combination with high capital leverage is lethal for carry traders.

(4) The Role of Technical Analysis

Some traders believe that technical analysis has no place in Carry Trade, but they are wrong. For example, let’s assume that you want to go long on NZDUSD, and that pair has already moved from 0.50 to 0.85 as it really happened between 2008 and 2011. Given that NZDUSD moves in long-term cycles between 0.40 and 0.88 that decision would prove catastrophic. Therefore, avoid going long on currencies that have already exhausted their upwards potential and will probably move the other way in the near future.

(5) The Extended Role of Central Banks

If a carry trader is long on a currency of an exporting country he is exposed to the risk of Central Bank interference. If the currency of an exporting country tends to appreciate a lot there is a high probability that the central bank will take action to prevent further appreciation. This kind of action may reverse the gains of Carry Trade.

(6) Carry Trade through a Basket of Pairs

By trading a basket of pairs and not a single pair you may reduce your risk exposure considerably. For example, instead of going long solely on AUDJPY you may also go long on NZDJPY. Furthermore, carry traders can implement a more sophisticated strategy and trade a full basket of currencies combining the three highest and the three lowest yielding Forex currencies. This approach is used by professional carry traders such as investment banks.

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■ Currency Carry Trade Strategy

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