What is a Carry Trade?
A carry trade is when you buy a high interest currency against a low interest currency. For each day that you hold that trade your broker will pay you the interest difference between the two currencies as long as you are trading in the interest positive direction.
Carry Trade Offers Two Ways To Profit
The Forex carry trade is a type of strategy in which traders sell currencies of countries with relatively low interest rates, and use the proceeds to buy currencies of countries that yield higher interest rates.
Forex carry trading leverages the differences in interest rates between countries. For example, one country’s central bank may lower interest rates in order to create economic stimulation, while the central bank in another country maintains higher interest rates.
In effect, the forex trader borrows money in one country with a lower interest rate, and invests it in another country with a higher interest rate, and keeps the difference in yield as profit.
A positive-carry forex trade (or simply “carry trade”) means that the position has a positive spread between the interest rates of the currencies. The carry trade strategy can capture this spread, and the profits depend on the leverage applied through the mechanical trading system.
How does carry trading work?
Carry trading offers forex traders an extra dimension of profitability. When the carry is positive, the forex position can accrue positive income even while market fluctuations cause a short-term loss in currency value.
For example, in buying one lot of EUR/USD, the trader is buying one lot of Euros, and selling one lot of Dollars. By maintaining the position overnight, the trader pays interest on that currency which was sold, and he or she receives interest for the currency which was purchased.
So, in this example, if the interest received from the purchased Euros is greater than the interest paid for the sold Dollars, the trading account gains simply by holding the position.
The longer the winning position is held, the greater the possible interest income and the thicker the cushion against fluctuations in the market.
A forex carry trade creates an extra opportunity for profit as well as a layer of additional protection. And, the carry trade can also increase the potential longevity of a holding.
Part of the appeal of forex carry trading is the possibility of earning interest. Typically, income accrues daily for long carries with triple rollovers.
Here’s the calculation to approximate daily yield:
[(Interest Rate of the Long Currency) – (Interest Rate of the Short Currency) / 365] x Notional value of the position
So, for example, for one lot of NZD/JPY with a notional value of 100,000 the interest can be calculated like this:
[(0.0333 – 0.0033)/365] x 100,000 = about $8 per day
This amount will be approximate, since banks use overnight rates which fluctuate daily. As well as yield for forex traders who are long NZD/JPY, traders whose strategies involve “fading” the carry, or else going short NZD/JPY can also earn interest.
Hedged Carry Trades
Yet another type of carry trade involves hedging one long carry trade with another short carry trade using different currency pairs that are closely correlated and which results in a net interest rate benefit to the overall position.
For example, a hedged carry trader might exploit interest rate differentials between well correlated currency pairs like the following:
EUR/USD and USD /CHF
AUD/USD and NZD/USD
GBP/USD and USD/CHF
EUR/JPY and CHF/JPY
GBP/JPY and CHF/JPY
Such hedged carry trades are often highly leveraged to make them worthwhile, thus much more risky. Nevertheless, the main risk to this hedged carry trade strategy arises if the correlation between the pairs breaks down for some reason and subsequently results in losses. Remember that the correlation risk is of course not the only risk factor to consider, just one of them.
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