Currency carry trade is one of the most popular trading strategies in the foreign exchange market and is based on the “buy low, sell high” strategy. While the forex market is responsive to several external stimuli making it one of the most volatile asset classes, the carry-trade strategy bears lower risk because it is based on the intrinsic interest rate difference between two currency pairs.
Key Takeaways
- The carry trade involves borrowing in a currency with a low interest rate and investing in a currency with a higher rate, allowing traders to earn interest on the difference.
- For instance, borrowing Japanese yen (with low rates) to invest in U.S. dollars (with higher rates) can yield profits through interest earnings and favorable exchange rate movements.
- Effective risk management is crucial, as changes in interest rates can significantly impact profitability. Traders should monitor economic conditions and adjust strategies accordingly.
- Optimal currency pairs for carry trading typically feature a substantial difference in interest rates, with low-yielding currencies like the yen paired with high-yielding currencies like the U.S. dollar.
How Does Carry Trading Work?
Traders typically borrow funds in a currency with a low benchmark interest rate and use the proceeds to buy a currency that has a high interest rate. The trader can then invest the high-yielding currency in corresponding government securities. This allows traders to pocket the interest earnings and sell the high-yielding currency and repay the borrowed funds and interest accrued in the low-yielding currency. If the exchange rates move in the trader’s favor, they can profit from the higher interest rate as well.
Carry Trade Strategy - Trade Example
The Japanese yen (JPY) has one of the lowest associated interest rates and is often used in currency carry trades. The Bank of Japan held the long-term, 10-year bond yield at 0%, while the short-term interest rate target is negative 0.1%. Consider the U.S. dollar (USD) as the high-yielding currency in this scenario, as the federal funds rate ranges between 4.75% and 5%.
Traders using currency carry-trading strategy to trade the USD/JPY currency pair will first borrow Japanese yen at the 0% rate. Assume the USD/JPY exchange rate is 133, and a trader borrows 10 million JPY and converts the proceeds to USD. The total greenback holdings will amount to about $75,188. If the trader invests their total holdings in a one-year U.S. Treasury bill bearing 4.75% interest, their total earnings would be about $78,759. As the total borrowing liability at a 0% interest rate remains $75,188, the trader will have effectively earned $3,571. For simplicity, the benchmark interest rates is assumed to remain constant throughout the year. But, if the Federal Reserve raises the federal funds rate during this period or if the Bank of Japan lowers its benchmark interest rate, the trader’s earnings would rise accordingly. But if the U.S. interest rate falls or Bank of Japan rates rise, the trader’s profit margin will shrink.
Benefits of Carry Trading the Currency Market
Carry trading might seem complex at first glance, but it is lower risk compared to other forex trading strategies. Carry trading on leverage also multiplies your profit potential. As central banks release the direction of future interest rate hikes beforehand, traders can use such publicly available information to their advantage. A changing monetary policy is usually the best time to engage in carry trading, as shifting interest rates can be highly profitable.
Risk Management in Carry Trading
Currency carry trades are directly impacted by changes in benchmark interest rates. Knowing the current economic backdrop and following the market expectations is key to properly managing risk while trading the interest rate differential in currencies. For instance, currency carry trading might not be the best option when the Fed is easing out of its hawkish stance, as it indicates lower or stagnant interest rates borne by the high-yielding currency. In addition, as most carry trades are highly leveraged, determining the optimal position size and entry and exit points is vital.
Traders should also be able to tune out market noise while engaging in currency carry trading, as it can lead to a premature sell-off of currency pairs and significant losses.
How Currency Pairs are Affected by Carry Trades
Currency pairs that have a material difference in interest rates are best for carry trades. For instance, traders choosing to carry trade the USD/EUR currency pair might not be able to maximize their profit margins, as the difference in their benchmark interest rates is less than 2%. Also, traders should select stable, low-risk currencies for carry trading because it lowers risk. The Swiss franc (CHF) and Japanese yen are popular low-yielding currencies, while stable high-yielding currencies include U.S. dollar, Canadian dollar and New Zealand dollar.
Carry Forex Trade Today
While it might seem daunting at first, currency carry trading can be highly profitable if executed properly. Understanding the mechanics of carry trading and ideal leverage and position size is key to a successful carry trade. Traders should note the market sentiment regarding interest rate hikes or declines in the near term.
As the Fed is currently planning to phase out its aggressively hawkish stance by the end of this year, the U.S. dollar might not be the best choice for the high-yielding currency. Adequate research regarding currency pairs and potential rate hikes in the near term is necessary before you begin carry trading.
Frequently Asked Questions
What are the best carry-trade currencies?
USD/JPY, USD/CHF and NZD/JPY are some of the best currency pair options to carry trade.
Is carry trade a good thing?
Yes, currency carry trade is one of the most popular forex trading strategies.
Is carry trading profitable?
Yes, currency carry trading can be immensely profitable if executed properly.