What is a carry trade in forex?

What is a carry trade in forex?

As mentioned in the article, “Interest Rates Drive Forex Prices,” interest rates play an integral role in driving currency prices. Interest rates also contribute to the concept of what is referred to as a carry trade.

A carry trade commonly refers to when traders invest in higher-yielding currencies with lower interest rates than their domestic currency and simultaneously invest in longer-term lower-yielding instruments denominated in their domestic currency.

The logic behind this strategy revolves around using the discrepancy between low yielding domestic investments and high yielding foreign investments for profit via borrowing rate differentials to achieve riskless returns. Most often used by major financial institutions, it takes enormous amounts of money management power to realize significant profits from this strategy.

Professional money managers can borrow cheaply in yen and invest in higher-yielding assets such as Australian or Brazilian bonds. The goal is to earn the spread between the low Japanese interest rates and the high Australian or Brazilian interest rates.

This activity will result in an appreciation of the foreign currency while the domestic currency depreciates (assuming all else remains equal).

What to remember.

While this may appear to be a simple strategy, it is essential to remember that movements in exchange rates can quickly offset any profits earned from interest rate differentials. Also, one must consider the risk associated with changes in foreign exchange rates which could lead to significant losses if not timed correctly.

Overall, carry trades can be profitable if used correctly but should be considered a complex investment strategy.

How to achieve Carry Trade

The most common way to achieve a carry trade is by using foreign exchange swaps or futures contracts. Swaps are agreements between two parties to exchange cash flows over a set period. In a Forex swap, one party exchanges their currency for another at an agreed-upon exchange rate. The second party then trades the currency back at a different exchange rate later.

Futures contracts are agreements to buy or sell a specific amount of a given currency at a set price on a particular date in the future. They are used to protect against changes in exchange rates between two currencies.

Many different factors can affect the success of the carry trade. The most important factor is interest rates, volatility, and political stability. Currencies with high-interest rates tend to be more volatile, increasing the risk of losing money in a carry trade.

Political instability can also lead to sharp changes in exchange rates, hurting traders who are long a high-yielding currency.

Some practical examples:

Example 1

Buying Japanese yen and Selling Australian dollar. In this example, we will trade the AUD/JPY currency pair.

First, we would go to our broker and borrow 100,000 yen at a rate of 0.01% per annum. We would then sell this 100,000 yen for USD 933.31 (at an exchange rate of 1 AUD = 94.61 JPY). Because we borrowed the yen at 0.01%, we pay $10 in interest for this trade ($0.01 x 100,000 = $100).

We now have $923.31 remaining from our original capital ($933.31 – $10 = $923.31). Next, we convert our Australian dollars back to Japanese yen by buying back the original amount of 100,000 yen with our$923.31. At an exchange rate of 1 AUD = 94.61 JPY, we now have 104,614 yen.

We have made a profit of 104,614 yen – $100 = $4,614 on this trade. This profit is the carry trade spread.

Example 2

Buying Japanese yen and Selling Canadian dollars. In this example, we will trade the CAD/JPY currency pair.

First, we would go to our broker and borrow 100,000 yen at a rate of 0.01% per annum. We would then sell these 100,000 yen for CAD 1,073.05 (at an exchange rate of 1 CAD = 97.68 JPY). Because we borrowed the yen at 0.01%, we pay $10 in interest for this trade ($0.01 x 100,000 = $100). We now have $1,063.05 remaining from our original capital ($1,073.05 – 10 = $1,063.05).

Next, we convert our Canadian dollars back to Japanese yen by buying back the original amount of 100,000 yen with our CAD 1,063.65. At an exchange rate of 1 CAD = 97.68 JPY, we now have 103,269 yen.

We have made a profit of 103,269 yen – $100 = $2,269 on this trade ($4,614 – 2240 = $2,269). This profit is the carry trade spread.