Carry Trade Strategies: Profiting From Interest Rate Differentials – Whether you invest in stocks, bonds, commodities or currencies, chances are you’ve heard of the carry trade. This strategy has generated positive average returns since the 1980s, but only in the last decade has it become popular among individual investors and traders.
For most of the past 10 years, the carry trade was a one-way trade heading north without major retracements. However, in 2008, carry traders learned that gravity always takes control when the trade crashes, wiping out seven years of gains in three months.
Carry Trade Strategies: Profiting From Interest Rate Differentials
Yet the profits made between 2000 and 2007 have many traders hoping that the carry trade will one day return. In this article, we’ll explore how a carry trade is structured, when it works, when it doesn’t, and the different ways short- and long-term investors can apply the strategy.
An Introduction To Carry Strategies
The carry trade is one of the most popular trading strategies in the forex market. Mechanically, doing a carry trade involves nothing more than buying a high-yielding currency and funding it with a low-yielding currency, similar to the adage “buy low, sell high”.
The most popular carry trades are to buy currency pairs such as the Australian dollar/Japanese yen and the New Zealand dollar/Japanese yen, as the interest rate spreads of these currency pairs are very high. The first step in setting up a carry trade is to determine which currency offers high yield and which offers low yield.
Interest rates for the world’s most liquid currencies are updated regularly on FXStreet. With these interest rates in mind, you can mix and match currencies with the highest and lowest yields. Interest rates may change at any time. Soforex traders should stay informed of these rates by visiting the websites of their respective central banks.
Given that New Zealand and Australia have the highest yields on our list while Japan has the lowest, it’s no surprise that AUD/JPY is the star child of carry trades. Currencies are traded in pairs, so all an investor needs to do to perform a carry trade is buy NZD/JPY or AUD/JPY through a forex trading platform with a forex broker.
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The low borrowing cost of the Japanese yen is a unique attribute that has also been capitalized on by stock and commodity traders around the world. Over the past decade, investors in other markets have begun to adopt their own version of the carry trade by shorting the yen and buying US or Chinese stocks, for example. This once fueled a huge speculative bubble in both markets and is why there has been a strong correlation between carry trades and equities.
One of the cornerstones of the carry trade strategy is the ability to earn interest. Income is accrued daily for long carry trades with triple rollover given on Wednesday to account for Saturday and Sunday rolls.
DailyInterest = IR LongCurrency − IR ShortCurrency 365 days × NV where: IR = interest rate NV = notional value begin &text = frac _text – text_text } } times text \ &textbf \ & text = text \ &text = text \ end DailyInterest = 365 Days IR LongCurrency − IR ShortCurrency × NV where: IR = interest rate NV = notional value
For example, imagine that the currency you are long on has an interest rate of 4.5% and the currency you are short on has an interest rate of 0.1%. Assuming a notional value of $100,000, we calculate interest as follows:
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.
The amount will not be exactly $12 because the banks will use an overnight interest rate that will fluctuate daily.
It is important to realize that this amount can only be earned by traders who are long the AUD/JPY. For those who vanish the carry or short the AUD/JPY, interest is paid daily.
For most people, the returns from direct carry trades are not very significant. However, these trades are often executed with leverage. In a market where leverage reaches 200:1, even using five to ten times leverage can make that return extremely extravagant. Investors may also favor carry trades as they earn interest income even if the currency pair does not move a penny. This is often not the case, as forex trading usually involves fluctuations in the value of currencies. However, it is possible to earn both interest income and capital appreciation with these types of transactions.
Exchange Rates In The Short Run: Deviations From Uncovered Interest Parity When We Studied Exchange Rates In The Short Run, We Examined Interest Arbitrage.
Carry trades also work well in low volatility environments because traders are more willing to take risk. What carry traders are looking for is yield – any capital appreciation is just a bonus. Therefore, most carry traders, especially large hedge funds that have a lot of money at stake, are perfectly happy if the currency doesn’t move a dime because they will still earn the leveraged return.
As long as the currency does not fall, carry traders will essentially be paid while they wait. Also, traders and investors are more comfortable taking risks in low volatility environments.
Carry trades work when central banks raise interest rates or plan to raise them. Money can now be moved from one country to another with the click of a mouse, and large investors are not shy about moving their money in search of not only a high return, but also a return increased. The appeal of the carry trade is not only in the return but also in the capital appreciation. When a central bank raises interest rates, the world takes notice and there are usually a lot of people who pile into the same carry trade, pushing the value of the currency pair higher in the process. The key is to try to enter the beginning of the rate-tightening cycle and not the end.
The profitability of carry trades is called into question when countries that offer high interest rates begin to lower them. The initial change in monetary policy tends to represent a major trend change for the currency. For carry trades to be successful, the currency pair must either not change in value or appreciate.
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When interest rates fall, foreign investors are less compelled to take a long position in the currency pair and are more likely to look elsewhere for more profitable opportunities. When this happens, the demand for the currency pair decreases and it begins to sell. It’s not hard to realize that this strategy instantly fails if the exchange rate devalues by more than the average annual return. With the use of leverage, losses can be even greater, which is why when carry trades go wrong, liquidation can be devastating.
Carry trades will also fail if a central bank intervenes in the forex market to keep its currency from rising or to keep it from falling further. For countries that depend on exports, an excessively strong currency could significantly reduce exports, while an excessively weak currency could hurt the profits of companies with overseas operations. Therefore, if the Aussie or the Kiwi, for example, become excessively strong, the central banks of those countries could resort to verbal or physical intervention to stem the currency’s rise. Any hint of intervention could reverse gains from carry trades.
An effective carry strategy does not simply involve going long a currency with the highest yield and shorting a currency with the lowest yield. While the current level of the interest rate is important, what is even more important is the future direction of interest rates. For example, the US dollar could appreciate against the Australian dollar if the US central bank raises interest rates at a time when the Australian central bank has completed its tightening. Additionally, carry trades only work when the markets are complacent or optimistic.
Uncertainty, worry and fear can cause investors to unwind their carry trades. The 45% sell-off in currency pairs such as AUD/JPY and NZD/JPY in 2008 was triggered by the subprime crisis that turned into a global financial crisis. Since carry trades are often leveraged investments, the actual losses were likely much larger.
Emerging Market Carry Trades
With respect to carry trades, at any time one central bank can keep interest rates stable while another can raise or lower them. With a basket of the three highest yielding currencies and the three lowest yielding currencies, a currency pair is only a portion of the entire portfolio; therefore, even if there is carry trade liquidation in a currency pair, the losses are controlled by owning a basket.
It is in fact the preferred way of trading for investment banks and hedge funds. This strategy can be a bit tricky for individuals as trading a basket would naturally require more capital. However, it can still be done with smaller lot sizes. Also, the key with a basket is to dynamically change portfolio allocations based on
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