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As a forex trader, you are aware of the importance that interest rates play in the financial markets. Central banks make decisions about interest rates based on many factors including the health of their domestic economy, inflation, unemployment, trade exports, and more.
There is a particular trade that involves the analysis of interest rate conditions of one country vs another as a primary decision point in evaluating a potential trade. This type of trade that we are going to discuss here is called the currency carry trade. In a currency carry trade, the intermediate and long term trader is looking to profit from the interest rate differential paid between the currency pairs.
In the carry trade, the investor can profit from both the interest rate spread and also from a favorable price movement in the currency. However, The direction of the currency pair is sometimes a secondary concern, as most carry trade positions are taken based on the width of the interest rate spread. We will explore how a carry trade works, a few trading strategies that can be employed, and some of the benefits and risks of the carry.
What is a Carry Trade?
So what exactly is a carry trade? Well before we dive too deep into this, let’s start off with what the term carry means as it relates to investing. Carry refers to the holding of any asset. When you buy an asset, you are basically carrying or holding that asset. So a carry trade at the most basic level is a trade aimed at making profit thru the exchange of one asset for another, each of with has its own unique carrying cost.
So let’s begin with a simple example. As an investor you are looking to put some money in a secured investment. So you decide on placing some of your allocated funds in a Certificate of Deposit (CD). Now thru some research you find out, for example, that you could borrow money in the United States, your home country for 3.5 % and invest it with an Australian Bank for a 6.50 % yield.
Well that seems like a no brainer. Your funds are insured at both banks, and so your investment and rate of return are guaranteed. So you decide to borrow from your American bank at a lower cost and deposit the funds at the Australian bank for a higher yield. By doing this, you have just entered into a carry trade transaction. It is considered a type of interest rate arbitrage trade.
So when holding one asset over another generates a profit, that is considered to have a positive carry. When holding one asset over another generates a loss that is considered to have a negative carry. In our example above, we have a positive carry when we borrow in US dollars and invest the proceeds in a CD with the Australian bank.
By using the currency markets, we can enter into a very similar transaction, and this technique is very popular among the biggest banks, hedge funds, and institutions. Nowadays, even small independent traders can enter into this type of trade. Essentially a currency carry trade can be done in the forex markets by borrowing a currency with a low interest rate and using that to finance the purchase of a higher yielding currency.
You would be paid this interest by your broker directly into your brokerage account for as long as you are holding a positive carry trade pair. And on the flip side, your account will be debited for the interest amount while you are in a trade with a negative carry pair.
How Carry Trading Works
So what are the mechanics of a carry trade in forex? To understand this a little better, we have to take a deeper look at what’s happening behind the scenes when we place a foreign exchange trade in the spot forex market. Have you asked yourself, for example, when you buy USDJPY or AUDJPY or any pair for that matter, what it is that you are really doing?
Well, let’s take the USDJPY to illustrate this further. When you enter into a USDJPY trade, you are in effect, buying the US Dollar and selling the Japanese Yen, at a fixed contract size, and at the prevailing exchange rate. All of us, understand that when we buy the USDJPY, we want the price of USD to rise in relation to the JPY. But at a more structural level, essentially you are borrowing the Japanese Yen to finance your purchase of the US Dollar.
Now let’s shift our attention to how a trader can make money in a carry trade. Well, as we have discussed already, a carry trade is an interest arbitrage trade technique, wherein we are looking for a high interest differential on a currency pair in order to realize an interest profit during our holding period.
If the price of the pair stays the same during the time you are in the forex carry trade, you will earn and interest profit. If the price of the pair moves in your favor during the time that you are in the carry trade, then you will have earned interest profit along with the capital appreciation of the currency pair. Those are some ways to benefits of a positive carry.
But the carry trade is not without risk and it has its own inherent challenges. Just because there exists an interest rate differential that we can take advantage of, there are other considerations to be made. If we enter into a positive carry trade, and the price of the currency pair decrease, then we stand to lose money due to this drop in the exchange rate. The amount would be dependent on the actual price drop and the corresponding leverage that we have used in the trade.
Many times the drop in price could outweigh any interest that you may have earned in the trade. Thus, even though we can earn a healthy interest return by investing in positive carry currencies, they are not without risk.
Rollover and Swaps
In the foreign exchange market, settlement takes place two days after a trade is booked. This is the time when the parities would exchange their currencies. This is where the Brokers come in, since most forex traders are not looking to take delivery of the currency. But then again, I don’t think any trader would mind if they were delivered a stack of hundreds at their front door. But I digress. Brokers handle this, by what is referred to as a Rollover, which means that positions are automatically rolled forward to the next settlement date on a continuous basis. So therefore, no physical delivery of the currencies is ever made.
Most Brokers tend to use the New York session close of 5pm Eastern time as the settlement time, but this can vary from broker to broker. There is special consideration made for trades between Wednesdays to Thursday. Since the settlement does not happen on the weekends, those trades are settled on Monday, with the additional two days of interest added.
A swap agreement also referred to as a swap, is a sort of foreign exchange agreement between the counter parties. Usually the dealing bank will use the overnight Libor rate plus a certain spread to calculate the interest due. Based on the arrangement that your broker has, it will then add is own fees to this to come up with the final swap value.
How to Calculate Carry Interest
As we have discussed thus far, one of the main advantages of a positive carry trade is the ability to earn passive interest income. This income is earned for every day that we are in a positive carry trade, or paid out for every day that we are in a negative carry trade. And since most Forex Traders, use leverage in their trading, the carry interest could really add up.
In this section, we are going to get into a little bit of math so that we can figure out how to calculate Daily Rollover interest
Daily Rollover Interest Credit / Debit =
Contract Notional Value x ( Base currency interest rate – quote currency interest rate )———————————————————————————————————————– 365 days per Year x Current Base Currency Rate
So let’s plug some numbers into this equation using the following hypothetical currency carry trade example for the EURUSD:
You are long 100,000 ( 1 lot) of the EURUSD, and at rollover the EURUSD is trading at 1.2000. The EUR short term interest rate is 4% and the USD short term interest rate is 2%
So let’s plug in the variables:
100,000 x ( .04 – .02 ) = 2,000 ———————————————— 365 x 1.20 = 438
2,000 / 438 = $ 4.57
So your daily rollover premium credit is $ 4.57. Since you are long the EURUSD you will earn this credit. On the other hand, if you were short the EURUSD, this would be a daily rollover debit, which you would have to pay.
Now this was a simplistic illustration to help you understand the formula. But keep in mind, the amount will differ somewhat, since banks use an overnight interest rate and that will fluctuate daily.
Now let’s take this one step further.
Based on this example, we want to calculate what our yearly yield would be assuming that the rate of interest paid will remain the same:
We would take $ 4.57 and multiply x 365 to arrive at $1,668.
Assuming you were trading with 10:1 leverage then this position would earn you 1,668 on $ 10,000 which results in a 16.68% return. Keep in mind, you are paid the interest not on the notational value, but on the levered amount of $10,000. There are forex carry trade calculators that are available that will make doing this exercise easy for you.
How to Find Good Carry Trade Pairs
When looking for potential candidates for a currency carry trade, we have to evaluate various factors to ensure that the trade has the highest chances for success. The first thing that we should do, even before looking at the differentials in the interest rate ratios, is to consider the financial stability of the countries for which we are looking to put on a carry trade.
You will find that the highest differentials can come from exotic pairs, but at the same time the highest risk also comes from these pairs due to financial uncertainly and less than stellar credit worthiness that some of these countries have. It would be wise for most traders who are interested in currency carry trades to try to stick with the major and minor pairs for the most part.
Next, we should compare the interest rate differentials among the currency pairs that have passed our test as far as countries with stable economies. There are some resources online that you could go to in order to find the highest yielding currency pairs. You should also be able to get this data from your broker platform, however, it is advisable to find an independent source where you could pull this data. Why? Because each Broker will pay a different yield. By using an independent source for this analysis, you will be able to find the Brokers that are paying the highest yield for the currency carry trade that you are interested in.
As of this writing, some of the more popular pairs for carry trades are the AUDUSD, AUDJPY, NZDUSD, and the NZDJPY. They represent currencies from stable economies with the highest interest differential ratios.
Another consideration should be whether the current interest rates for the currency pairs is expected to change. Do we expect interest rates for the currency we are buying to increase relative to the other over the period that we are holding it? This is not always any each question to answer, but some thought should certainly go into this as well. Furthermore, we should take time to do some technical chart analysis on the chosen pair. Consider what the chart is telling us and decide whether it makes sense from the technical standpoint to enter into the carry trade. By doing this additional analysis, it may provide us with a stronger reason to enter into the position or it may give us a reason to pass on the trade altogether. The point is that there is much more to setting up a good carry trade candidate than simply looking at those pairs with the highest yields.
Forex Carry Trade Strategies
Though every trade with a positive carry position will earn some interest, the carry trade strategy is more suitable for longer term investors whose trading time horizon is in months or years. One of my favorite quotes of all time is by Jesse Livermore. He said
“It never was my thinking that made big money for me. It was always my sitting. Got that? My sitting tight!”
The majority of the time, the big bucks come from sitting tight and waiting, doing nothing. The carry trade embodies this type of thinking.
Buy and Hold Carry Strategy
The first type of strategy that a trader could employ around a carry trade is the basic buy and hold strategy. After you have done your research regarding the economic viability of the countries, the interest rate differential, potential interest rate movement, and the broker yields, you are ready to select the currency pair that you find meets your criteria. With the Buy and Hold strategy, you will simply buy the selected positive carry pair and hold it for a fixed period of time. It could be 3 months, 6 months, 1 year or longer.
Basket Buying Carry Strategy
In any type of investing, diversification is usually the best hedge against adverse events that could cause substantial damage to your bottom line. It is certainly no different in trading. Diversification across a basket of positions will typically provide a smoother equity curve and produce an optimal return to drawdown ratio.
So, using this concept we could purchase a basket or portfolio of carry trade positions. As a result, any adverse price reactions will only have a nominal effect on our entire portfolio. This is usually how professional banks and hedge funds implement their carry trade strategies.
Carry Trading with Technicals
Technical traders will also find benefit in the carry trade. Most technical traders tend to have a shorter term time horizon, usually having open positions lasting days or weeks. So how could this class of traders take advantage of the carry trade? We’ll take a look at that shortly. One thing to recognize around the carry trade, is that when the interest rate differential widens on a pair, longer term traders come into the market to take advantage of this interest spread. As the larger participants are entering the trade, that increases the demand for the currency which drives the price of the currency higher. So in effect, the strong interest rate differential brings in more institutional demand and that acts drives prices higher as well.
A Technical trader could utilize a trend following technique to get in on these trades. In addition a swing trader could wait for pullbacks and dips to enter and add positions while prices are moving in their favor. Be wary of utilizing counter trend strategies on pairs that have a strong carry. That would be an uphill battle at best. You would be going up against the daily accrued interest charges and a potentially strong trending market. So be careful of that. Trading is difficult to begin with, why makes thing harder than they need to be.
As a recap, we should keep in mind that while executing the carry trade setup, we have to be selective and do a thorough analysis to ensure that we are choosing only the highest probability carry trade setups. This entails studying the current economic conditions in the countries we are interested in, and applying additional fundamental and technical analysis methods as well.
The carry trade is not for the very short term trader, but instead should be used as a longer term trade approach. We have seen that the carry trade offers a dual benefit to the trader in terms of being able to earn interest income and potential upside on the price appreciation as well. But do keep in mind that the carry trade does have its own inherent risks which should be minimized using sound position sizing and money management principles.