What is Carry trade strategy and how to use it

Carry Trade in Forex

Intro

Studying various fx strategies, you might come across the carry trade. The carry trade is a strategy that allows traders to capitalize on the difference in interest rates of countries. This strategy is one of the reasons why interest rates are so important in FX. Any divergence in interest rates may result in the redirection of billions of dollars, thus, a huge profit or loss of a trader. So, how does a carry trade work, and how to calculate carry trade returns? If this is what you're wondering, read about the role of interest rates in the strategy and learn the best ways to implement the strategy in 2021.

The carry trade is a strategy that allows traders to capitalize on the difference in interest rates of countries.

What is the Carry Trade?

The carry trade enjoys huge popularity among currency traders. In simple words, the carry trade definition can be put as "a strategy that implies borrowing from a low-interest currency to buy high-yielding currency". Because of the dependence on interest rates, this strategy may lead to profit or loss even under the condition of static long-term currency pair rate. It is considered to be a medium or long-term strategy as its implementation can take from a few weeks to months or even years.

Carry Trade in Forex

The Role of Interest Rates in FX Carry trade

Various factors, such as inflation and economic growth, can impact interest rates. These factors are influenced by the countries’ monetary policies when their central banks change interest rates in order to control consumer prices and support economic growth. Generally, once a country wants to stimulate the economy it reduces the interest rate, making it easier for consumers to borrow and subsequently spend more money. Another country may be fighting inflation, thus, decides to raise the interest rate aiming to encourage people to spend less. Interest rates can vary from country to country. This creates an opportunity for investors to borrow one currency (the one with a low interest rate) and invest it in another currency (the one with a high interest rate).

How to Choose a Currency Pair

What you are interested in when looking for the right currency pair for implementing the Carry trade strategy is a big interest rate spread. For years, the New Zealand dollar/Japanese yen and the Australian dollar/Japanese yen have been considered the most reliable options.

Once you know interest rates, it will be easier to find an appropriate currency pair for implementing the carry trade strategy. So, learn which currency gives a high yield and which one gives a low yield before you start testing the strategy.

Learn which currency gives a high yield and which one gives a low yield before you start testing the strategy.

Another important factor in choosing the pair is that it shouldn’t be prone to high volatility. If the currency rate turns against you and your asset depreciates, the loss may outweigh the profit from the interest rate.

When to Get in a Carry Trade

Rising interest rates create the best environment to start a carry trade. On the contrary, when central banks reduce interest rates, currencies tend to depreciate, which is undesirable, as it gets more difficult to sell the currency due to low demand. Plus, the strategy works best in times of low volatility, minimizing losses from rate fluctuations. The best scenario for a trade is when the currency’s value either grows or shows no change.

How to Calculate Carry Trade Profit

The carry trade allows investors to profit from the interest rate as much as from the pair’s price movement. No matter whether the price of your asset grows or stays the same, you receive a daily interest from a swap (transfer of open trading position through the night). Remember that the swap can be either positive and negative, this is why your primary concern is choosing the right currency pair. To calculate the interest you gain, use the carry trade formula:

Daily interest
NV × (IR Long currency - IR Short currency)
365 days × Currency pair quote
* where: IR = interest rate; NV = notional value

Currency Carry Trade Example

Suppose investor A sees the potential for a carry trade in the AUD/JPY pair. When he goes long AUD/JPY, he buys the Australian dollar while selling the Japanese yen. Or let’s put it this way, he is borrowing the yen in order to fund your Australian dollar purchase. If the price for his asset (AUD/JPY) remains unchanged for a while, he gains profit in the form of daily swaps. If the pair goes up in price, our investor benefits from both interest profit and capital appreciation of the pair. Both scenarios result in what’s called a positive carry. Suppose the AUD short-term interest rate is 3.5% and the JPY short-term interest rate is 1%. Let’s use the above-mentioned carry trade calculator to evaluate the potential income of investor A who borrows 10,000,000 yens in order to buy the Australian dollars, considering AUD/JPY = 83.21.

10,000,000 × (0.03500 - 0.01000) = 250,000
365 days × 83.21 ≈ 30,371
250,000 / 30.371 ≈ $8.23 AUD/day

Note that it is a rough estimate for the situation in which the currency rate doesn’t change.

On the other hand, if the AUD/JPY declines to the extent that overweighs the interest he earns, our investor loses money due to the depreciation of his asset. This is why the carry trade performs best for low volatility pairs.

Carry Trade in Forex

Risks Associated with Carry Trades

The most common risk associated with the Carry trade strategy is the unpredictability of exchange rates. The carry trade pair may experience a bigger decline than the gain in the interest rate. In this case, the loss in the capital will surpass the gain in interest. Suppose an investor goes long AUD/JPY. If the aussie falls in relation to the yen, his trade will lose value. The loss hits him even harder if he uses leverage and the trade isn’t hedged appropriately.

Following the direction of a monetary policy, interest rates tend to change from time to time and sometimes it’s hard to predict their further direction. Any change in interest rates can drastically affect the outcome of a trade.

The Carry Trade in 2021

For years, AUD/JPY and NZD/JPY have been widely exploited for implementing the carry trade strategy. With higher yields of the Australian and New Zealand dollar, compared to other currencies, and low interest rates in Japan, these two pairs were perfect for a carry trade. The whole idea was in borrowing the Japanese yen at low interest rates and investing in the Australian or New Zealand dollar.

Now, with the pandemic and economic crisis, central banks have cut interest rates in both New Zealand and Australia. That makes it harder to identify the AUD/JPY as the best currency pair for a carry trade. The Reserve Bank of Australia keeps the interest rate near zero. In a situation like this, it is harder to treat the AUD/JPY as a ready-made solution. So, is the strategy still viable? The answer is yes!

Bringing interest rates close to zero, the world central banks opened opportunities to look at some of the exotic currency pairs that haven’t suffered lowering interest rates that much. Some currencies of developing countries, such as ZAR, BRL, and MXN may be worth your attention as they are supported by some of the world’s highest interest rates. However, you should take into account that these currencies are more volatile. So, if you decide to carry trade exotics, you should be considering all the risks.

How to Learn the Carry Trade with Demo Accounts

Justforex offers a vast variety of currency pairs, including multiple exotics. If you want to learn to carry trade, we recommend you open a demo account and find a currency pair that has a positive swap. Check the swap size in the Market Watch" window in the MT4 platform. You can do this with a right-click on the currency pair and selecting "Specification". If you feel ready to trade real money and win, don’t hesitate to open a trading account on Justforex.

Conclusions

The carry trade is one of the most popular Forex trading strategies that can be briefly explained as "buy low, sell high." Traders speculate on the width of interest rate spread, gaining daily income from a swap. The carry trade is a medium to long-term strategy, often implemented with the use of leverage. When choosing the right currency pair, traders look for a compromise of a wide interest rate spread and relatively low volatility. Traditionally, the most popular currency pairs for the strategy are AUD/JPY and NZD/JPY due to their wide interest rate spreads.

by Justforex, 2021.03.01

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