October 16, 2017
In forex, you can make money even if the price of the currencies doesn’t move. In fact, many large investors with a large amount capital do this, and it’s called “carry trade”.
A carry trade involves buying a currency which pays a larger interest rate, and simultaneously selling or borrowing a currency with a lower interest rate. In this trade, you are collecting the higher interest rate on the currency you bought, while paying a lower interest rate on the currency you sold or borrowed. You make a profit only from the interest rate differential of the currencies involved.
It’s a simple yet very profitable strategy, considering the daily interest payments in the forex market and the availability of leverage. If you hold a position overnight, your broker will automatically credit/debit your account with the overnight interest rate difference. This is also called “rollover cost” in the FX jargon.
The following table shows the current interest rates on major currencies in October 2017.
In the past, a popular carry trade was buying AUD and selling JPY, but most central banks slashed their interest rates to spur economic growth and inflation after the 2008 economic crisis. The NZD/CHF pair offers the largest interest rate differential as of October 2017. A simple long position on NZD/CHF would collect a 2.50% yearly interest rate, but with the help of leverage, the possible profit can be much larger (as well the loss if the position goes against you.)
When do Carry Trades Work?
Carry trades work best when risk-aversion among investors is low. This means, they are optimistic and want to buy higher-yielding currencies and sell lower-yielding ones. When risk-aversion is high (i.e. a risk-off market environment), investor will put their money into safe-haven, low-yielding currencies such as the US dollar, Swiss franc and Japanese yen, which will make them appreciate in value. The capital loss on selling/borrowing these low-yielding currencies in carry trades will then offset any interest gain.
Market expectations of future interest rate hikes are also important, as countries that perform well might have to hike their interest rates in order to control inflation. This in turn will have a direct impact on a carry trade position.
On the other hand, when a country is not performing that well, chances are it will have to lower interest rates to spur economic activity.
Criteria and Risk of Carry Trades
As mentioned above, finding a possible carry trade is pretty simple. All you have to do is to watch for (1) the interest rate differential, and (2) for an uptrend of the higher-yielding currency.
As you can see, the AUD/CHF pair fulfills both criteria. The pair has a 2.25% interest rate differential, and the following chart shows that the Australian dollar is trending up since late 2015.
However, just like any trade, carry trade involves the risk that the position goes against you (i.e. AUD falls in value), offsetting any interest gain. To prevent this, you should put an appropriate stop-loss that will protect you against heavy losses, but that still gives enough room for the pair to fluctuate as carry trade is longer term strategy.
Carry trades can be very profitable if the interest rate differential is high and if the high-yielding pair is trending up, especially with the use of leverage. A carry trade involves buying a higher-yielding currency and selling or borrowing a lower-yielding one. The interest rate differential represents the potential profit if the price of the pair remains flat, and the interest rates don’t change. Your broker will automatically add the interest gain to your account if you hold the position overnight, called rollover. However, today’s interest rates are relatively low compared to past numbers, and you should always use a stop-loss to limit your risk if the trade goes against you.
Test Your Knowledge: What is a Carry Trade
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What is a Carry Trade
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Question 1 of 3
As of October 2017, which pair offers the largest interest rate differential?Correct
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Carry trades work best when risk-aversion among investors is low.Correct
Question 3 of 3
When a country’s economy is not performing well, chances are it will ___ interest rates to spur economic activity.Correct