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TE05 - What is a Currency Carry Trade?

"A currency carry trade is a type of strategy that is derived from what is known as a carry trade approach. A carry trade simply means that the trader or investor borrows funds and pays interest on it, in order to fund something else which gives a higher rate of return. Carry trade is commonly used across many markets but primarily found in the bond markets. A customized version of the carry trade is used in the currency markets, which gives it the name currency carry trade. The basic purpose of carry trade is to seek for a low funding currency in order to fund a higher yielding currency. Interest rates and their differences forms the premise for currency carry trade. While this strategy can give good returns, the performance of this strategy is depended on a number of factors which can last for years. Thus a currency carry trade is not always advisable to be used unless you have your ear to the markets."

A few years ago, right after the financial crisis, carry trade strategy became the global theme. As many central banks lowered interest rates, investors were able to fund their operations by borrowing in a currency with lower interest rate to fund either the equities or to deposit the converted currency into a higher yielding interest rate currency.

A good example of this was the Japanese yen. Back in the days, the Japanese yen’s interest rate was close to zero. Therefore, investors used the carry trade approach and borrowed the Japanese yen.

They then converted the yen into the U.S. dollars and invested the money in U.S. equity markets. This carry trade was partly responsible for the massive bull market in the U.S. equities right after the 2008 global financial crisis.

It was not just the Japanese yen and the U.S. dollar. The Australian dollar was also a currency that had a higher yielding interest rate. Thus investors could borrow the yen and then park their funds in AUD in order to get a higher rate of interest.

Carry trade, isn’t as simple as borrowing funds and then parking it in a higher yielding currency. Traders need to account for a number of things such as the fluctuating exchange rates. Monetary policy also played an important role in determining the success of using a carry trade strategy.

How does currency carry trade work?

At the very core, the currency carry trade follows the aspects of buying low and selling higher. In carry trade terminology, this is as simple as selling a currency that had a lower rate of interest and purchasing a currency with a higher rate of interest.

The trader or investor typically tends to make a profit by the interest rate differential.

In the larger scheme of things, currency carry trade is used to fund the equity or other investment opportunities that gives a higher rate of return. Thus, carry trade is not just confined to interest rate differentials.

It is all about how much profit a trader or an investor could make. After deducting the cost of borrowing, the bottom line should be that the investor still retains a healthy profit.

In the forex markets, when one talks about currency carry trade, they often think about selling a currency with lower interest rate and buying a currency with higher interest rates.

For example, if you look to the markets today, a USD/JPY currency pair offers a good carry trade opportunity. The Japanese yen interest rate currently stands at -0.10%. This means that if you bought the Japanese yen, you would be charged an interest rate of 0.10%.

On the other hand, the interest rates in the United States stands at 2.25%. This means that if you bought the Japanese yen, you would be debited with an interest rate of 2.25% on an annualized basis.

This, the ideal solution would be to be long on the USD/JPY currency pair. In other words, you would be selling the Japanese yen (with the cost of carry at 0.10%) and be long on the USD with the cost of carry at 2.25%.

After deducting the interest rates, you would still be able to make a profit of 2.15%. Of course, now account this profit for the currency pair’s exchange rate fluctuation as well. If the USD/JPY managed to also appreciate, then you would also be making a big profit.

Does currency carry trade still work?

While the carry trade strategy was one of the most talked about and widely invested methods, now a days, it has lost its relevance. Many central banks around the world have shifted from a hawkish to a dovish monetary policy.

Interest rates around the world have been steadily falling. What this means for you as a trader is that the carry trade isn’t as lucrative as it used to be. But of course, there can also be opportunities forming.

As an example, the Australia dollar used to demand a higher interest rate just a few years ago. At the time of writing, the RBA cut rates to 1.50%. This is a historic low for the AUD in terms of interest rates.

Thus, a once upon a time favorite currency for carry trade strategy has fallen out of favor with many. As you can see by now, currency carry trade strategy does have its periods of when this strategy can yield good returns, but at the same time, there are periods when this strategy basically becomes worthless.

Read 942 times Last modified on Friday, 26 July 2019 16:31