Currency Carry Trade: What is it and how does it work?

Pipscollector.com - A currency carry trade involves borrowing a low-yielding currency in order to buy a higher yielding currency in an attempt to profit from the interest rate differential. This is also known as “rollover” and forms an integral part of a carry trade strategy. Traders gravitate towards this strategy in the hope of collecting daily interest payments over and above any currency appreciation from the actual trade.

This article explains FX carry trades with the use of examples and presents a top carry trade strategy to use in your trading.

WHAT IS A CURRENCY CARRY TRADE AND HOW DOES IT WORK?

An FX carry trade involves borrowing a currency in a country that has a low interest rate (low yield) to fund the purchase of a currency in a country that has a high interest rate (high yield). Holding this position overnight will result in an interest payment being made to the trader based on the “positive carry” of the trade.

The lower yielding currency is referred to as the “funding currency” while the currency with the higher yield is referred to as the “target currency”.

Rollover

“Rollover” is the process whereby brokers extend the settlement date of open forex positions held past the daily cut-off time. The broker either debits or credits the account, based on the direction of the trade (long or short) and whether the interest rate differential is positive or negative. Since interest is quoted as an annual figure, these adjustments will be the daily adjusted rate.

Interest rates

Interest rates are set by a country’s central bank in accordance with the mandate of that country’s monetary policy – this will differ from country to country. A trader then earns interest on a position when they are long the currency in the pair with the higher interest rate. For example, if the Australian dollar offers 4% and the Japanese Yen has interest rates set at 0%, traders could look to buy (long) AUD/JPY to take advantage of the 4% net interest rate differential.

There are two main components to the FX carry trade:

1) Changes in interest rates

The main component of the carry trade is centered around the interest rate differential between the two traded currencies. Even if the exchange rate between the two currencies remains unchanged, the trader will profit from the overnight interest payment. However, over time, central banks deem it necessary to alter interest rates and this poses a potential risk to the carry trade strategy.

2) Exchange rate appreciation/depreciation

The other component of the carry trade strategy focuses on the exchange rate of the two currencies. A trader looks for the target currency to appreciate (increase in value) when long. When this happens the payoff to the trader includes the daily interest payment and any unrealised profit from the currency. However, the profit the trader sees, as a result of the target currency appreciating, will only be realised when the trader closes the trade.

It is possible for a trader to lose money when the target currency depreciates against the funding currency so that the capital depreciation wipes out the positive interest payments.

CURRENCY CARRY TRADE EXAMPLE

Continuing with the example used above, if the Australian Official Cash Rate is currently at 4% and the Japanese Yen yields 0%, a trader may decide to take a long trade on AUD/JPY if the pair is likely to rise.

Traders looking to capitalise on the interest rate differential will essentially be borrowing Yen at the much lower rate and receiving the higher interest rate associated with the Australian dollar. In reality, retail traders will receive less than 4% as forex brokers usually apply a spread.

For a detailed example of how to calculate the approximate overnight interest charge/gain, read our article on understanding foreign exchange rollover.

THE RISKS INVOLVED WITH CARRY TRADES

A currency carry trade, like most trading strategies, carries a degree of risk and therefore, requires the adoption of sound risk management. Risk management has become even more important since the 2008/09 global financial crisis which resulted in lower interest rates for developed nations, forcing carry traders to look to riskier, high yielding emerging markets currencies until interest rates normalize.

• Exchange rate risk: Should the target currency weaken against the funding currency, traders that are long the pair will see the trade move against them but will still receive the daily interest.

• Interest rate risk: If the country of the target currency reduces interest rates and the country behind the funding currency increases interest rates, this will reduce the positive net interest rate and is likely to reduce the profitability of the FX carry trade.

FX CARRY TRADE STRATEGY

Filtering FX carry trades in the direction of the trend is one such strategy employed by top traders. This is because the carry trade is a long term trade, and therefore, it’s useful to analyse markets that exhibit strong trends.

In an attempt to get into higher probability trades, traders should first look to confirm the uptrend which, in the below chart, is confirmed after the higher high and higher low.

The figure depicts higher highs and higher lows whereby a break of the horizontal line (drawn at the first higher high) confirms the uptrend. Thereafter, traders can make use of multiple time frame analysis and indicators to spot ideal entry points to enter a long trade.

CONCLUSION

Currency carry trades present traders with two avenues to profit (exchange rate and interest rate differential) but it is essential to manage risk as losses are can arise when the pair moves against traders or the interest rate differential narrows.

For higher probability trades, traders should look for entry points in the direction of an uptrend and should protect downside risk by utilizing prudent risk management techniques.

IMPROVE YOUR FOREX TRADING STRATEGY WITH OUR RESOURCES AND GUIDES

• Successful FX carry trades rely on upward trending currency pairs (target currency/ funding currency), so it is essential for traders to be able to identify trends.
• If you are just starting out on your forex trading journey, you can learn the basics with our free New to Forex guide.

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