Carry trade is one of those trading strategies that is quite suitable especially for the foreign exchange market. We have seen in our series of trading strategies that certain techniques and tools are more suitable for certain markets and not others. This article we are going to focus on a really forex-y strategy!
So in carry trade strategy the forex trader will set out to borrow a certain amount of assets in the form of a foreign currency which has a lower interest rate compared to another for the purposes of investment in another currency. Now, this second foreign currency has a higher interest rate than the previous one.
In this way the trader is able to pocket the difference between the two interest rates as the profit made from the carry trade strategy. But there is so much more than that.
A Closer Look at Carry Trade Strategy
In more technical terms, we can define a carry trade as a form of investment. Because it is more like an investment than an actual trade. In this form of so-called “investment” the trader will in fact sell a currency with a lower rate and use the proceeds to buy another foreign currency with a higher rate.
And when we are talking about rate we are of course talking about the interest rate of that currency set by its respective central bank. And through the difference that exists between the difference in the two currencies’ interest rates the trader will profit.
The way that happens is that the trader will sell the second currency in the foreign exchange market or the forex market and that is how profit is obtained through carry trade strategy.
The Mechanisms Behind Carry Trade Strategy
The Mechanisms Behind Carry Trade Strategy
One key feature of carry trade strategy is that it relieves the trader from the usual rigmarole of forex trading. This means with this strategy, traders do not have to race in the market to buy low and sell high.
Instead, the way the carry trade strategy works is through the difference between the interest rates of foreign currencies. And that is exactly how traders make profits.
Keep in mind that the most important mechanism behind this trading strategy is a concept known as interest positive trajectory of trade.
Interest positive trajectory is that you as a trader would go from a low interest rate currency to a high interest rate currency. If this trajectory is negative or even neutral, then carry trade does not work.
What Is the Risk Associated with Carry Trade?
There are risks involved with any form of trading strategy. No technique would be without its potential challenges posed to the trader.
One of the biggest risks associated with carry trade strategy is that when you purchase the second asset, its value could go through fluctuations that are not ideal for your position – i.e. it could experience a price decrease.
Furthermore, if you do not know how to choose the two currencies, the difference between them can result only in losses. This means when you sell the first currency, also called borrowing at a lower rate, and then you buy the second one with a higher rate, and the difference between them is just too much, the carry trade strategy will not work out the way you want it to. So careful consideration is required when picking the currencies.
These challenges are among the reasons why carry trade is apparently more ideal for big market participants such as institutional traders.
What Currencies Are Mostly Used with Carry Trade?
What Currencies Are Mostly Used with Carry Trade
The most important factor that you need to know in using the carry trade strategy is that the most ideal currencies are those that have the highest degree of difference in their interest rates – i.e. the spread in their interest rate.
As such, there are currencies such as New Zealand Dollar and Japanese Yen, or Australian Dollar and Japanese Yen. The reason these pairs of foreign currencies work well with carry trade strategy is again due to the fact that they have a higher spread in their interest rates.
How to Use Carry Trade Strategy?
The first thing you need to do if you want to use the carry trade strategy in forex trading is finding the right currencies. As we discussed earlier, the right currencies would be the ones that yield an interest positive trajectory. We provided two suggestions, but there are of course many others that can be found through research.
This research would be done by looking up the currency’s respective central bank, and then checking on the interest rate offered for that currency.
After you have chosen your currency pair, you need to make sure that the two chosen currencies do not exhibit a high degree of fluctuations or volatility.
Remember, if fluctuations get the best out of the situation, then the trade is no longer in your control. You can no longer count on the interest rate spread, because no matter how much the spread will be in your favor, the changing price will result in ultimate loss of assets.
An Example of the Carry Trade Strategy
Provided that you have calculated all the aspects of the trade correctly and precisely, then when you have locked in your carry trade, you can just hold on to it and you will earn profits on the account of the difference between the interest rates.
So, let’s take a look at a simple example. As of 2023, the interest rates for the most traded currency pair in the forex market, i.e. British pound sterling and the United States dollar shown as GBP/USD, is as follow:
- British pound interest rate: 7.11%
- United Stated dollar interest rate: 5.5%
The interest rate for the United States dollar has recently been increased and currency stands at 5.25% but it is expected to rise to 5.50% in the coming month – in the last quarter of 2023.
And as for the UK interest rate, it has been held at an average rate of 7.11% for the past 50 years – to be exact ever since 1971.
So as you can see the spread between the interest rates of these two currencies stands at exactly 1.61%.
So this is the amount of profit you will earn for holding the trade or position that consists of the British pound and the US dollar. You earn 1.61% interest paid by the broker everyday on a daily basis.
It might not seem like much, but that is only because the currency we have chosen does not exhibit a very high degree of interest rate spread.
However, at the same time, you need to keep in mind that when these interests add up on a daily basis they can become substantive.
Conclusion
Carry trade is a form of popular trading strategy that is mostly used in the foreign exchange market or the forex market. The way the carry trade strategy works is that you sell a currency and buy another one. But not because you want to buy low and sell high. But rather you want to sell one with a lower rate of interest rate and then buy another one with a higher rate of interest rate. certain currency pairs have a higher difference in their interest rate, known as the spread in their interest rate.
