Introduction to Carry Trade

Introduction to Forex Carry Trade

Carry Trade is an effective long-term trading strategy and a strong force driving key Forex trends.

 

What is Forex Carry Trade?

Forex Carry Trade means selling a low-interest-rate currency and buying the same amount of a high-interest-rate currency. The concept is to make money based on the interest-rate differential.

Popular Currencies for Carry Traders

A carry trade will go long on currencies such as the New Zeeland Dollard, the Australian dollar, or the Turkish Lira, and go short on currencies such as the Japanese yen and the Swiss Franc.

The most popular currency pairs for carry trading are:

■ AUD/JPY, NZD/JPY, EUR/JPY, USD/TRY, and GBP/CHF

Carry Trade can also mean borrowing in a low-interest-rate currency, converting it to a high-interest-rate currency, and buying the highest-rated bonds (check the Yen Carry Trade below).

 

When Central Banks Change their Rates?

Carry trades can prove very effective when central banks increase or plan to increase the level of domestic interest rates. Central banks change the level of the domestic interest rates aiming to achieve long-term financial stability and growth.

(↑) Why Central Banks Increase Interest Rates?

• To respond to high inflation (by reducing the money supply)
• To deal with a capital shortage (by making the rates more attractive to foreign investors)
• To deal with political or financial turmoil that may have caused an aggressive currency devaluation

(↓) Why do Central Banks Decrease Interest Rates?

• To stimulate the economy (by boosting consumption)
• To deal with high unemployment (by boosting investment)
• To make the cost of borrowing lower for risk-takers and thus boost growth
• To stop an aggressive domestic currency appreciation (which may have jeopardized the potential for higher exports and growth)

The “ZIRP Policy” (zero interest rate policy) implemented by several central banks nowadays has created several opportunities for carry trading.

■ More about Forex Fundamentals: http://carrytrader.com/carry-trade/trading-forex-fundamentals

 

 

General Conditions for Successful Carry Trade

These are some general conditions for successful carry traders:

(1) Entering the Beginning of the Interest Rate Cycle

As mentioned earlier, carry trading is very effective when central banks increase or plan to increase the level of interest rates. The key for carry traders is to enter at the beginning of the interest rate cycle.

Example: Since 1992, the rate of the Australian Dollar moves in a broad range between 1.5% and 7.5%. Currently, it is found at 1.5% and that means that it is close to starting a new interest rate cycle.

(2) Timing Carry Trades by using Technical Analysis

Even though carry traders are fundamentalists, they should always take a look at technical analysis charts. A carry trader follows long-term trends, and in that sense, he needs to perform chart analysis. Carry traders don’t want to trade against the master trend, nor to enter a market that is about to correct.

• The long-term trend is your friend

(3) Use Trading Leverage with Caution

Carry traders can use capital leverage to earn higher profits. Nevertheless, using capital leverage means also accepting higher risks. A general approach is to adjust the rate of capital leverage to deal with the incurred volatility. In any case, the leverage on carry trades should never exceed 10:1, favorably 5:1.

• Higher volatility → lower capital leverage
• Lower volatility → higher capital leverage

(4) Low-Volatile Assets are Preferable

Carry trades are more effective in a low-volatility environment. Large carry traders, such as hedge funds, prefer to trade currencies that are not very volatile. Hedge funds can predict with relative precision the outcome of low-volatile investments.

• Low-volatile assets have more predictable returns than high-volatile assets.

(5) Avoiding Uncertainty

Carry traders should always focus on healthy economies that can offer long-term growth opportunities. Opening carry-trade positions in an economic environment where the domestic rates increase due to panic and massive capital outflows is not wise. Capital flight creates a problematic economy that incurs enormous risks.

• Focusing on healthy economies

 

The Yen Carry Trade

Carry Traders tend to sell the Japanese Yen (JPY) as it is a currency traditionally offering low-interest rates.

How Does the Yen Carry Trade Works?

Big investors tend to borrow funds in Yen and buy high-rated US assets, let’s see an example:

(i) An investor borrows 1 million USD in Yen (¥111,855,000)

(ii) The yen amount is converted to US dollars

(iii) The 1 million USD is used for the purchase of US Treasuries

(iv) The investor earns the difference between the yield of US treasuries and the interest cost for the borrowed yen

(v) After some time, the investor sells the US Treasuries, then, converts US Dollars to Yen and pays back its initial loan

When is the Yen Carry Trade More Effective?

At times when the Bank of Japan (BoJ) aims to produce a flexible (cheap) Yen, this practice may be very profitable. Note that the Bank of Japan is an almighty player in the global Forex market as it holds massive foreign exchange reserves.

■ BoJ holds currently 1,260 billion USD in Foreign Exchange Reserves (more on IMF)

■ Find more about Foreign Exchange Reserves: http://carrytrader.com/carry-trade/forex-reserves

Chart: The Japanese Yen Interest Rates

 

 

Conclusions Regarding Carry Trade

 

The interest rate differential between two currencies can create significant opportunities for carry trading. Since the year 2000, carry trade has become a popular long-term trading strategy for large investors and currency hedge funds. There are two main carry trade strategies:

(1) Borrowing Yen, converting them to US Dollars, and buying US Treasury Bills (the Yen Carry Trade)

(2) Trade the extreme interest rate differentials of specific Forex Pairs (i.e. AUDJPY, NZDJPY, USDTRY, and GBPCHF)

The problem for carry traders is that the lower-yielding currencies are reserve currencies representing countries of great financial status. On the other hand, higher-yielding currencies are usually very volatile currencies. That is why carry traders need to be very careful when choosing high-yielding currencies. Furthermore, capital leverage should be used with caution, and never exceed 10:1. Volatility should be seen as the key to unlocking the optimal rate of capital leverage for each carry trade.

It seems that carry trading has become one of the key drivers of long-term Forex trends. Carry trading affects not only the Foreign Exchange market but other major financial markets, as well. The practice of carry trading causes the appreciation of the US Dollar against low-yield currencies such as the Japanese Yen and the Swiss Franc. In addition, carry trade causes the appreciation of the US bond and equity markets. Finally, as the US Dollar moves higher, commodity prices (which are priced in USD) tend to depreciate in order to re-balance the equilibrium between supply and demand.

 

 

■ Introduction to Forex Carry Trade

George Protonotarios for CarryTrader.com ©