Getting Smart With Carry Trade - Things That Make you in Long Term Profit
Is it possible to earn some passive income while you hold certain currency positions over a period of time? The spot forex market offers just that opportunity.
The Carry Trade Strategy is a popular way of trading the global forex market, and is a strategy highly favored by large financial institutions such as hedge funds, pension funds and banks. What makes carry trades so desirable is the possibility of earning interest, which is a unique aspect that traders – both big and small alike – can take advantage of.
All currencies in the world have interest rates attached to them, and these rates are decided by each country’s central bank. For example, the Federal Reserve Bank in the US determines the country’s interest rates while the Bank of England sets the United Kingdom’s interest rates. Since each country sets its own interest rate, countries – or, rather, their currencies – are bound to have varying interest rates. Some countries may have relatively higher interest rates while others may have relatively lower rates.
How can traders exploit the fact that some currencies have much higher interest rates than others? Let me introduce you to the concept of a carry trade.
A carry trade is a long-term fundamental trading strategy that involves the selling of a certain currency with a relatively low interest rate, and using the funds to buy a currency which gives a higher interest rate, with the hope that the high-interestrate currency will appreciate against the low-interest-rate-currency.
When these positions are held overnight, carry traders are paid interest on the currency they are long in, and must pay interest on the currency they are shorting. The interesting aspect of this strategy is that the investor or trader is able to gain the difference between these two interest rates, known as the interest rate differential or spread, which can be a hefty amount when leveraged.
• Currencies with typically high interest rates: GBP, NZD, AUD, CAD
• Currencies with typically low interest rates: JPY, CHF
The Japanese yen and the Swiss franc tend to be on the selling side of the carry trade due to their traditionally low interest rates. Such low-interest-rate currencies are known as funding currencies since they are used to fund the purchase of high interest rate currencies such as the British pound, the New Zealand dollar or the Australian dollar which tend to have high interest rates.
EXAMPLE: CARRY TRADE
Here is an example of a carry trade. Let’s say the Japanese yen has an interest rate of 0.25%, and the New Zealand dollar gives an interest rate of 7.25%. Since the New Zealand dollar has a higher interest rate than the Japanese yen, a trader who wishes to profit from a carry trade may buy the New Zealand dollar and sell the Japanese yen at the same time.
An annualised profit of around 7% (7.25% - 0.25%) may be reaped from the carry trade if no leverage is used. This return is based on the assumption that the exchange rate between the New Zealand dollar and Japanese yen remains unchanged throughout the holding period of one year. If that carry trade is carried out with a 10 times leverage, it will increase the unleveraged 7% annualised return to a huge 70% annualised return.
The conventional notation of currency pairs is such that JPY and CHF tend to be the counter currency while GBP, NZD and AUD tend to be the base currency in a currency pair. Hence, traders who are interested in carry trades will long currency pairs like GBP/JPY, AUD/JPY or NZD/CHF, effectively buying the first currency in each pair (which also tends to be the higher-yielding currency) and simultaneously selling the second currency in the pair (which tends to be the lower-yielding currency).
Since they are trading these currency pairs in the long direction, they will want the base or high yielding currencies to strengthen in value against the counter or low yielding currencies.
This act of shifting huge amounts of money into high-yielding assets lays the foundation of the carry trade, since a carry trade is all about borrowing money at low interest rates and then using the funds to purchase higher yielding financial instruments from elsewhere, which can include bonds or even cash itself. For quite some time, institutional or individual investors have been able to enjoy and exploit the large interest rate spread between US and Japan.
Investors were drawn to borrowing the Japanese yen at near zero percent interest rate and using the money to buy US treasury bonds which gave them a much higher rate of return.The conversion of Japanese yen into US dollars for the purchase of the US bonds has resulted into a form of carry trade even though the asset may not be in cash because these assets are nonetheless denominated in the high-interest-rate currency. So it does not matter if investors are moving their money into bonds, currencies or other instruments, because it is ultimately cash that is changing hands.
This conversion from one currency to another is significant if it is done on a large scale as an increased demand for that high-interest-rate currency will cause that currency to appreciate against the low-yielding currency. Usually, birds of the same feather will flock together, with money attracting more money to the same place as other investors follow suit.
Forex traders, sensing this snowballing effect, will then execute carry trades in the currency market, with the hope that there will be a continued demand for the high-yielding currency as they can then profit from the interest spread as well as from capital appreciation.
Generally speaking, developed countries that offer relatively high interest rates are those which tend to experience decent economic growth and expansion, which may in turn attract more foreign investment into their country. An economy that is doing reasonably well will more likely be able to pay high interest rates to investors.
However, it is not just the more developed countries that may offer high interest rates; many emerging economies may do so as well, simply because they tend to experience higher inflation. These are generally not countries where most investors will park their money due to the high level of economic instability.
Political stability is also another aspect that investors are concerned with because a politically stable country will provide a good framework for trade and investment.
Adverse economic and/or political conditions could have a negative impact on foreign investment in the country, and may cause investors to move their assets out and convert the high-yielding currency into their local currencies, thus resulting in depreciation in exchange rates of the carry pair.
On the other hand, a narrowing interest rate gap between the two currencies will cause traders and investors to lose interest in holding their carry trades and discourage more people from joining in the carry trades as the interest fees paid out will decrease. Such a scenario can occur when interest rate hikes are expected to take place in the country of the low-yielding currency, thereby lifting the currency from the current low interest rate, or when interest rates are expected to be cut in the country of the high-yielding currency. So as a rule of thumb, the wider the interest rate gap exists between the two currencies, the higher the likelihood of a profitable long-term carry trade.
Depreciation of the high-yielding currency can cause carry traders to lose money, as they are betting on an unchanged or a rising exchange rate of the currency pair, and this decline can even erase any gains earned from the interest.
Should market sentiment reverse and change due to economic, monetary or political conditions, carry traders may decide to liquidate their long positions (by selling), perceiving that the highyielding currency would drop in value, and thus harm their long trades. This unwinding can come about quickly and without much warning, and can usually last for quite some time (months or even years) especially if overall perception towards the currencies in the carry pair is changed drastically based on major fundamental changes. Another reason for the possible prolonged unwinding of carry trades is that not all carry trades will unwind at the same time.
Has it been moving in an uptrend, downtrend or sideways? If the overall fundamental picture looks supportive of a carry trade, you may position yourself for a possible uptrend by buying near price or trendline support levels or by trading upside breakouts. Since carry pairs could be trending upward for quite a while, they make good candidates for trading trendline or price support bounces.
Exercise extra caution when you see that the currency pair has been trending south over the intermediate and long-term time frame because that clearly shows a gradual liquidation of long positions by carry traders and investors. In that case, the Carry Trade Strategy is not recommended for that currency pair at that time.
I would advise a minimum holding time frame of at least three months for a carry trade, provided that the market sentiment does not turn adversely against the preferred direction of the carry trade. Reasonable (i.e. not tight) stops must be put in place if your carry trades are to endure short-term market fluctuations without being stopped out.
LEVERAGE
Institutional players tend to execute the Carry Trade Strategy with some amount of leverage. Leverage has the power to transform single-digit returns into superpowered double-digit ones. Independent traders may also apply leverage (preferably not more than 10 times) for carry trades so as to potentially increase their rate of return. But, of course, leverage works both ways.
As much as it can be a highly desirable tool to increase your profits, it can also be a highly destructive weapon that is capable of magnifying your losses. New traders can often get too carried away with the prospect of being able to use high leverage that they overlook the importance of money management.
Use a moderate amount of leverage with caution as excessive leverage has the capacity to diminish your trading capital in a short time.
The Carry Trade Strategy is a popular way of trading the global forex market, and is a strategy highly favored by large financial institutions such as hedge funds, pension funds and banks. What makes carry trades so desirable is the possibility of earning interest, which is a unique aspect that traders – both big and small alike – can take advantage of.
All currencies in the world have interest rates attached to them, and these rates are decided by each country’s central bank. For example, the Federal Reserve Bank in the US determines the country’s interest rates while the Bank of England sets the United Kingdom’s interest rates. Since each country sets its own interest rate, countries – or, rather, their currencies – are bound to have varying interest rates. Some countries may have relatively higher interest rates while others may have relatively lower rates.
How can traders exploit the fact that some currencies have much higher interest rates than others? Let me introduce you to the concept of a carry trade.
WHAT IS A CARRY TRADE?
When these positions are held overnight, carry traders are paid interest on the currency they are long in, and must pay interest on the currency they are shorting. The interesting aspect of this strategy is that the investor or trader is able to gain the difference between these two interest rates, known as the interest rate differential or spread, which can be a hefty amount when leveraged.
A Basic Carry Trade Strategy
- 1. Buy a currency with a high interest rate, and
- 2. Sell a currency with a low interest rate
• Currencies with typically high interest rates: GBP, NZD, AUD, CAD
• Currencies with typically low interest rates: JPY, CHF
The Japanese yen and the Swiss franc tend to be on the selling side of the carry trade due to their traditionally low interest rates. Such low-interest-rate currencies are known as funding currencies since they are used to fund the purchase of high interest rate currencies such as the British pound, the New Zealand dollar or the Australian dollar which tend to have high interest rates.
EXAMPLE: CARRY TRADE
An annualised profit of around 7% (7.25% - 0.25%) may be reaped from the carry trade if no leverage is used. This return is based on the assumption that the exchange rate between the New Zealand dollar and Japanese yen remains unchanged throughout the holding period of one year. If that carry trade is carried out with a 10 times leverage, it will increase the unleveraged 7% annualised return to a huge 70% annualised return.
The conventional notation of currency pairs is such that JPY and CHF tend to be the counter currency while GBP, NZD and AUD tend to be the base currency in a currency pair. Hence, traders who are interested in carry trades will long currency pairs like GBP/JPY, AUD/JPY or NZD/CHF, effectively buying the first currency in each pair (which also tends to be the higher-yielding currency) and simultaneously selling the second currency in the pair (which tends to be the lower-yielding currency).
Since they are trading these currency pairs in the long direction, they will want the base or high yielding currencies to strengthen in value against the counter or low yielding currencies.
MORE MONEY WILL FOLLOW THE MONEY
Global institutional investors, such as hedge funds and banks, are constantly on the lookout for the highest rate of return on their funds, and have no qualms about shifting their money around, in the global sense.
This act of shifting huge amounts of money into high-yielding assets lays the foundation of the carry trade, since a carry trade is all about borrowing money at low interest rates and then using the funds to purchase higher yielding financial instruments from elsewhere, which can include bonds or even cash itself. For quite some time, institutional or individual investors have been able to enjoy and exploit the large interest rate spread between US and Japan.
Investors were drawn to borrowing the Japanese yen at near zero percent interest rate and using the money to buy US treasury bonds which gave them a much higher rate of return.The conversion of Japanese yen into US dollars for the purchase of the US bonds has resulted into a form of carry trade even though the asset may not be in cash because these assets are nonetheless denominated in the high-interest-rate currency. So it does not matter if investors are moving their money into bonds, currencies or other instruments, because it is ultimately cash that is changing hands.
This conversion from one currency to another is significant if it is done on a large scale as an increased demand for that high-interest-rate currency will cause that currency to appreciate against the low-yielding currency. Usually, birds of the same feather will flock together, with money attracting more money to the same place as other investors follow suit.
Forex traders, sensing this snowballing effect, will then execute carry trades in the currency market, with the hope that there will be a continued demand for the high-yielding currency as they can then profit from the interest spread as well as from capital appreciation.
FACTORS SUPPORTIVE OF CARRY TRADES
Good economic and political conditions of the high-yielding currency When it comes to deciding where to invest their money, investors will not only assess the rate of return, but also the economic conditions and political stability of the country which holds the assets.
Generally speaking, developed countries that offer relatively high interest rates are those which tend to experience decent economic growth and expansion, which may in turn attract more foreign investment into their country. An economy that is doing reasonably well will more likely be able to pay high interest rates to investors.
However, it is not just the more developed countries that may offer high interest rates; many emerging economies may do so as well, simply because they tend to experience higher inflation. These are generally not countries where most investors will park their money due to the high level of economic instability.
Political stability is also another aspect that investors are concerned with because a politically stable country will provide a good framework for trade and investment.
Adverse economic and/or political conditions could have a negative impact on foreign investment in the country, and may cause investors to move their assets out and convert the high-yielding currency into their local currencies, thus resulting in depreciation in exchange rates of the carry pair.
WIDENING INTEREST RATE GAP
The wider the difference in interest rates between the two currencies in a pair, the higher the interest that will be paid to traders who long the carry pair (with the highyielding currency as the first currency in the pair) over a period of time. And the higher the interest fees that will be paid, the more it will attract other traders or investors to enter carry trades, thereby potentially pushing up the value of the highyielding currency further as demand for it increases.
On the other hand, a narrowing interest rate gap between the two currencies will cause traders and investors to lose interest in holding their carry trades and discourage more people from joining in the carry trades as the interest fees paid out will decrease. Such a scenario can occur when interest rate hikes are expected to take place in the country of the low-yielding currency, thereby lifting the currency from the current low interest rate, or when interest rates are expected to be cut in the country of the high-yielding currency. So as a rule of thumb, the wider the interest rate gap exists between the two currencies, the higher the likelihood of a profitable long-term carry trade.
RISKS INVOLVED IN CARRY TRADE
The biggest risk in the Carry Trade Strategy is the uncertainty of future exchange rate fluctuations. For a carry trade to work, the high-yielding currency must rise, or at the very least remain steady, against the low-yielding one over a period of time.
Depreciation of the high-yielding currency can cause carry traders to lose money, as they are betting on an unchanged or a rising exchange rate of the currency pair, and this decline can even erase any gains earned from the interest.
YOU MUST UNDERSTAND THE FUNDAMENTALS
If you are thinking of employing the Carry Trade Strategy, you must first understand the fundamental factors that are supportive of carry trades, and be confident that the high-yielding currency will continue to rise or stay unchanged against the low-yielding currency over a period of time.
Should market sentiment reverse and change due to economic, monetary or political conditions, carry traders may decide to liquidate their long positions (by selling), perceiving that the highyielding currency would drop in value, and thus harm their long trades. This unwinding can come about quickly and without much warning, and can usually last for quite some time (months or even years) especially if overall perception towards the currencies in the carry pair is changed drastically based on major fundamental changes. Another reason for the possible prolonged unwinding of carry trades is that not all carry trades will unwind at the same time.
POINTS OF ENTRY
Once you have evaluated the fundamental factors that are supportive of a profitable long-term carry trade, the next thing to do is to look at the technical picture of the carry pair that you are interested in (or you can check out the technical outlook first before assessing the fundamental factors). Open up the daily or weekly chart of the pair and see how it has been moving over the intermediate and long-term time frame.
Has it been moving in an uptrend, downtrend or sideways? If the overall fundamental picture looks supportive of a carry trade, you may position yourself for a possible uptrend by buying near price or trendline support levels or by trading upside breakouts. Since carry pairs could be trending upward for quite a while, they make good candidates for trading trendline or price support bounces.
Exercise extra caution when you see that the currency pair has been trending south over the intermediate and long-term time frame because that clearly shows a gradual liquidation of long positions by carry traders and investors. In that case, the Carry Trade Strategy is not recommended for that currency pair at that time.
OTHER CONSIDERATIONS
While the Carry Trade Strategy has the potential means to maximise your trading profits, there are a few things to keep in mind when planning a carry trade. Holding time frame Traders must be aware that this strategy is not meant for short-term trading, as time is instrumental in the realisation of decent profits.
I would advise a minimum holding time frame of at least three months for a carry trade, provided that the market sentiment does not turn adversely against the preferred direction of the carry trade. Reasonable (i.e. not tight) stops must be put in place if your carry trades are to endure short-term market fluctuations without being stopped out.
LEVERAGE
As much as it can be a highly desirable tool to increase your profits, it can also be a highly destructive weapon that is capable of magnifying your losses. New traders can often get too carried away with the prospect of being able to use high leverage that they overlook the importance of money management.
Use a moderate amount of leverage with caution as excessive leverage has the capacity to diminish your trading capital in a short time.
About Kuldeep Nikam
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