The Carry Trade

The Carry Trade technique is one of the best known and employed in the financial world. Most institutions and management businesses implement it, and it is a simple way to earn money. This strategy works as follows: You borrow from a low interest rate currency and buy a currency with a higher interest rate. The goal is to make profits from the spread or difference between both interest rates.

Source: http://www.fxstreet.com/fundamental/interest-rates-table/

For example, let’s examine Australian Dollar versus Japanese Yen. According to the table above, the Reserve Bank of Australia is applying an interest rate of 4.75% while Bank of Japan has a 0.1% rate (those are average numbers, there is another spread to take into account for buying or selling transactions). Calculating the profit made on swaps (daily roll-over interest paid or charged from the banks) is easy: 4.75 minus 0.1 is equal to a 4.74% yearly profit on your position when you are buying Australian Dollar and selling Japanese Yen (buying AUD/JPY currency pair). This by itself is not extremely exciting, but in Forex, thanks to the enormous power of leverage, it can become a very interesting option.

In Forex transactions, your broker gives you the possibility of selling or buying any currency pairs that you want. You can then chose a pair where the interest rates of both currencies are far apart from each other. You then open the position in the appropriate direction and every night, when markets close, you will be earning the interest rate differential.

Every broker lists either on their websites or inside their platforms, the SWAP percentages for every currency pair and market direction. You earn or lose that interest differential every trading day at the market close. Week-end roll-over is usually paid or charged on Wednesday (triple-swap day). You’ll only have to take a position so to earn the higher rate and pay the lower interest.

Forex Carry Trade: how to apply it

On the Forex market, transactions are made by pairs, as for example the EUR/USD. When you buy EUR, you are selling USD. You pay interest over the currency you are selling (USD) and gather interests on the currency that you buy. Every night, at the end of the trading day, your broker credits or debits from your account the roll-over or swap which is the differential of the interest rates of all the pairs on which you are holding open positions.

There is a great advantage in Forex to apply the Carry Trade technique, as every day your broker performs those calculations. Over a year period, if that differential between the currencies is of 4% favoring the euro (or as in our example above, 4.74% favoring the Australian Dollar) and you have bought and held EUR/USD for a whole year, the accumulation of all the swaps that you will have earned for that period will be equal to 4% of the amount invested, minus a small percentage that brokers apply for commissions.

Of course, this will only happen in case the prices for EUR/USD haven’t changed throughout all the year. This is a quite rare phenomenon. There are two other possibilities:

1. Prices are lower, and even if you have earned 4% over the year, you will lose more than this when you resell the pair. You can even face the situation where the pair has fallen so much that you get a margin call.
2. Prices are higher and in this case you earn both the swap differential and your profits made on the transaction because of price rise. This is the Jackpot!

Therefore, it is very important to chose carefully which pair are you going to use to apply the Carry Trade technique. You will have to apply a previous analysis to be sure that the direction in which the position has favorable swaps is the same as where the market seems to be going, medium to long-term.

The risks of the Carry Trade

As said above, the greatest risk of the Carry Trade is the fact that the trade could evolve in the wrong direction regarding the position taken (LONG or SHORT).

The second risk of the Carry Trade is the evolution of interest rates for the currencies involved. If those change against your position, you can lose a part of the differential between interest rates, which in turn can considerably harm your profits. Furthermore, when the difference shrinks because of a rate modification, there is usually a massive resell or buying spree (depending on the direction in which the Carry Trade was favorable), as all investors try to get rid of their positions, trying to avoid getting caught in a “snow-ball effect” (in fact fueling directly this very effect by their actions…).

Let’s illustrate this fact with an example on USD/JPY. As you probably know, the Central Bank of Japan has always had interest rates near to 0. On the other hand, American Central Bank used to have much higher interest rates. Everybody was then selling Yen to buy Dollars. But, mid-2007, when the sub-prime crisis intervened, the FED started lowering its rates. The Carry Trade was therefore becoming less and less interesting and little by little the investors went on unwinding their positions, which brought about a fall in prices. This fall itself brought in turn massive unwindings of carry trades (the carry trade was only profitable if USD/JPY rate was rising). Dollar/Yen rate fell then from 123 to 96 in less than a year (2700 pips). This was absolutely devastating for those who were holding their positions. Of course, for a while they kept earning on swaps (due to the rate differential still in place) but the rate fall led them to lose a lot of money!

In short, when rates don’t move and if there is no major event, the Carry trade can possibly be a very profitable operation (swaps and spot rate going in your direction). However, if there is a reversal of the economic situation that brings about an evolution of the rates, you better react promptly!

To apply the Carry Trade technique and limit your risk from the start you need to have two conditions in place:

- Find an attractive rate differential

- Find a pair which long term trend is going in the direction of your carry trade position.