Last Updated on 3 November, 2022 by Samuelsson
Did you know there is a currency trading strategy that can make money the exchange rates stayed exactly the same for long periods of time? In fact, the carry trade strategy is a $14 trillion game in the Forex market. Interestingly, the strategy can also be applied to other assets. But what is this carry trade strategy about?
A carry trade is a trading strategy that involves borrowing or selling a financial instrument with a low interest rate and using it to purchase a financial instrument with a higher interest rate, such that while you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased. In essence, your profit is the money you collect from the interest rate differential. In the FX market, a typical carry trade involves using a low-interest-rate currency to buy a high-interest-rate currency.
In this post, you will learn the following:
- What a carry trade strategy is
- Why carry trades work
- How to calculate carry trade: the carry trade formula
- Examples of carry trade in real life
- What a positive carry trade is
- How to carry a trade
- Carry trade advantages
- Carry trade risks: why a carry trade might end badly
- Tips for carry trade strategies
What is a carry trade strategy?
A carry trade strategy involves borrowing at a low-interest rate and investing in an asset that provides a higher rate of return. Typically, it is based on borrowing in a low-interest rate currency and exchanging the borrowed amount to another currency with a higher interest rate where it would be deposited to yield higher interest. The borrowed money could also be used to buy assets that are denominated in the second currency, such as stocks, commodities, bonds, or real estate.
While a carry trade strategy can be used on any asset — for example, borrowing at a low interest rate from the EU region to buy government bonds from a third-world country like Nigeria — it is mostly used in Forex trading, especially by long-term position traders who see it as an alternative to the usual “buy low and sell high” method.
The carry trade strategy is easy to implement — sell a low-interest currency and buy a high-interest currency. It can be as easy as going long on the high-interest currency that is quoted against a low-interest currency. So, for each day that you hold that trade, your broker will pay you the interest difference between the two currencies, since you are trading in the interest-positive direction.
For instance, let’s assume the Great British pound (GBP) has a 3.5% interest rate while the US dollar (USD) has a 0.75% interest rate. If you go long on the GBP/USD pair, your trade can be called a carry trade because for every day that the trade is on the market, the broker will have to pay you the difference between the interest rates of those two currencies — that is, the day’s equivalent of the 2.75% annual rate. Over time, the interest rate difference can add, and a trader can even magnify the return by using huge leverage.
The most popular carry trades in the forex market involve buying currency pairs like the Australian dollar/Japanese yen (AUD/JPY) and New Zealand dollar/Japanese yen (NZD/JPY) because the interest rate spreads of these currency pairs have been quite high and the exchange rate fluctuations are minimal. However, such a perfect currency pair for carry trading may not be available or, to say the least, may not be offered by your broker.
In that case, you may have to make two complementary trades. For example, if you want to play a carry trade with AUD/JPY and your broker doesn’t offer the currency pair, you can simultaneously go long on USD/JPY and AUD/USD because the two trades will be equivalent to going long on AUD/JPY, and here is the explanation: When you are long USD/JPY and AUD/USD, it means you sold JPY to buy USD and sold USD to buy JPY. Overall, you are net long AUD and short JPY.
Of course, the first step in putting together a carry trade is to find out which currency offers high interest and which one offers low interest. However, the currency pair must have minimal exchange rate fluctuations for you to effectively play a carry trade strategy with it; if not, a negative price fluctuation can eat up the interest rate difference and may even result in a losing trade.
Why do carry trades work?
To understand why and how carry trade can work in various markets, let’s consider some scenarios with the various markets.
Many credit card issuers offer a 0% cash advance for limited periods. A retail investor may decide to take the cash advance and invest in an asset with a higher yield for as long the 0% interest rate on the cash advance lasts. Interestingly, to lure customers to use their credit cards, some credit card issuers offer 0% interest for periods ranging from six months to as long as a year. However, they often require a “transaction fee” of 1% paid up-front. So, if the retail investor takes a cash advance of say $10,000, for a year, the cost would be 1%. If the fellow invests this borrowed amount in a fixed income security, say a one-year certificate of deposit (CD) that carries an interest rate of 4%, the carry trade would result in a 3% (4% – 1%) profit or $300 ($10,000 x 3%).
Let’s assume the investor decides to invest the $10,000 in the stock market, instead of a CD, and the expected return on the investment in one year is 10%. If, at the end of the one year, the investment makes a 10% return, the investor would have made a 9% profit. However, there is still the risk that the stock market could perform poorly and the investment loses 10% or more by year-end when the borrowed money could be due. In this case, the investor loses 11% on the carry trade, instead of making a profit of 9% as intended.
Carry trade in forex
Let’s say that a Forex trader notices that the Turkish lira offers a 7% interest rate, but at the same time, the Fed lowered the interest rate to 0.0% to stimulate the U.S. economy. This trader can decide to go long on the Turkish lira (TRY) against the U.S. dollar (USD), so he sells the USD/TRY pair. If the exchange rate between the dollar and lira remains the same for the entire year, the trader makes 7% in profit from the interest. Assuming he bets $10,000 in the market, selling 0.1 lot of USD/TRY without any leverage, he earns the 7% profit or $700. However, if the exchange rate fluctuated positively, such that the TRY appreciated by 10%, the trader’s return would be 17% (7% + 10%) or $1,700 profit. On the other hand, if the TRY depreciated by 10%, the return would be -3% (7% – 10%) or $300 loss.
Using leverage to play a carry trade strategy in Forex
Let’s assume the trader’s broker offers as much as x100 leverage, but the trader decides to use x10 leverage. The trader can place his $10,000 capital as a good faith deposit (initial margin) and trade 1 standard lot size, which is worth $100,000. So, he goes short 1 lot on USD/TRY. The broker charges him 0.5% interest (since the Fed rate is 0.0) on the borrowed money, while he gets 7% interest from the lira for the year.
If the exchange rate between the USD and TRY remains the same, he would make 6.5% (7% – 0.5%) of the $100,000 in profits. That will be $6,500. Assuming the trader is lucky and the exchange rate fluctuates in his favor by 10%, his return would be 16.5% (6.5% + 10%) or $16,500 profits. However, if the exchange rate fluctuated against his position and the lira depreciated by 10%, his return would be -3.5% (6.5% – 10%) or a $3,500 loss.
Is carry trade arbitrage?
Carry trade is different from the usual arbitrage trading that you know, where a trader tries to benefit from the price difference between two or more markets by striking a combination of matching orders that capitalize on the imbalance in the markets. In fact, carry trade and arbitrage are two of the most useful trading strategies used by forex traders, even though some consider carry trade a particular type of arbitrage trading despite their unique features.
However, carry trade arbitrage may be considered an uncovered interest rate arbitrage since it involves an investor capitalizing on the interest rate differential between two countries without covering for the exchange rate risks. This is unlike covered interest arbitrage whereby the investor uses a forward contract to hedge against exchange rate risks while trying to benefit from the interest rate differential.
Although hedging reduces the size of potential profits in covered interest arbitrage, it protects the arbitrageur from the possibility of the exchange rate going significantly against his position as can happen in carry trade (uncovered interest arbitrage), which involves no hedging of foreign exchange risk with the use of forward contracts
So, the carry trade strategy involves risk — the trader is exposed to exchange rate fluctuations but is speculating that exchange rates will remain favorable enough for carry trade to be profitable. Such traders are willing to take on the risk, so he tries to invest in whichever currency is expected to offer a higher rate of return including currency exchange gains or losses.
How to calculate carry trade: the carry trade formula
So far, you have learned that with a carry trade strategy, you borrow in low-yield currency and invest in high-yield currency — that is, you sell your low-yield currency to buy high-yield currency. Of course, the key feature of the carry trade strategy is the ability to earn the difference in interest rates. The interest is accrued every day with a triple rollover given on Wednesday to account for Saturday and Sunday rollovers.
The carry trade formula is a bit complex, but basically, the daily interest is calculated in the following way:
Daily Interest = [(IRLong Currency – IRShort Currency ) / 365 days] x NV
IRLong Currency = interest rate per annum in the currency bought
IRShort Currency = interest rate per annum in the currency sold
NV = notional value
Let’s take an example using a 1 lot of NZD/JPY that has a notional of $100,000. If we assume that the interest rate for AUD is 5.10% (0.051) and that of the JPY is 0.1% (0.001), in this case, we will compute daily interest as follows:
[(0.051 − 0.001) / 365] × $100,000
≅ $13.70 per day
Of course, the amount will not be exactly $12 since the banks will use an overnight interest rate, which fluctuates on a daily basis. One more thing to note is that this amount can only be earned by traders who are long NZD/JPY. Those who are short on the pair will have to pay the interest every day.
An example of a carry trade opportunity in real life
One of the best examples of carry trade could be seen in the early part of the century — between January 2000 and May 2007. During this period, the Australian dollar/Japanese yen currency pair (AUD/JPY) had an average annual interest difference of 5.14%. While this may look small, some traders used leverage to multiply their returns — x10 leverage would turn the return to over 50% per annum, while x30 leverage would turn it to over 150% return per annum.
Of course, investors earned this return even when the currency pair failed to move one cent. However, with so many people getting involved with carry trades, the currency rarely stayed stationary. Interestingly, the pair mostly moved in favor of those who were long AUD during that period.
What is a positive carry trade?
As we have already stated, currency carry trade comes with a risk of exchange rate fluctuations, which can go against the trader’s position. If the exchange rate losses are bigger than the interest rate differential the trader was targeting, the trade will end up a loser. On the contrary, when the return from a carry trade is positive (carry trade profit), the trade could be referred to as a positive carry trade.
A positive carry trade, therefore, results when the trade has a positive interest rate differential and the trade is making a positive return. It could be that there are minimal price fluctuations of the exchange rate between the currencies in the pair, or it could be that the exchange rate fluctuations were in the trader’s favor, thereby earning him more returns.
Another scenario is when the exchange rate fluctuation is against the trader but the extent is still smaller than what the trader is making from the difference in interest rates. Whatever the case, it is a positive carry trade if the interest rate differential is positive and the trader makes a positive return at the end of the tenure.
How do you carry a trade?
There are different ways to use the carry trade strategy, depending on the markets you are interested in, but the first step is to find a currency you can borrow at a low interest rate and another currency that offers a higher interest rate or an asset that offers a higher return.
Using a forex market example, you should identify a currency pair in which one currency offers high interest and the other offers low interest so that there is a significant interest rate difference. Also, the currency pair must not be too volatile; if not, a negative price fluctuation can eat up the interest rate difference and may even result in a losing trade.
However, it may not be easy to find such a currency pair on your broker’s platform. In that case, you may have to simultaneously trade two currency pairs that will give you the combination you need. For example, if you want to sell the Japanese yen to buy the Turkish lira and benefit from its 17% interest rate, your broker may not offer TRY/JPY which you can simply buy. What you do is find two trade combinations that can give you the position you want.
In this case, you can go long on USD/JPY, which means you are selling the Japanese yen to buy the USD. At the same time, you go short on USD/TRY, which means you are selling the USD to buy the Turkish lira. So, this combination — long USD/JPY and short USD/TRY — gives you what you want, which is to go long on TRY/JPY.
The advantages of a carry trade strategy
The carry trade strategy offers you some advantages. As long as you’re in a positive carry trade, you’ll make profits daily, even if the market is stagnant and the exchange rate relevant to your trade does not move, because you will earn from the positive difference interest rates.
And, if the exchange rate fluctuations move in your favor, you will profit from the interest paid on your carry currency as well as from any appreciation in the value of the currency pair. If you make use of leverage and control a large amount in your trade, your returns will multiply — both the one from interest rate difference and the one from positive exchange rate fluctuation.
So, trading in the direction of a positive interest rate difference is a huge advantage when you are trading with leverage because when your broker pays you the daily interest on your carry trade, the interest paid is on the leveraged amount and not on your small trading capital. For example, if you open a trade, say a full standard lot size, which is worth $100,000, when you only have only $5,000 in your trading account, you will be paid daily interest on $100,000, and not $5,000. So, your returns can easily add up to a large amount.
Carry trade risks: why might a carry trade end badly?
There are two main risk factors involved in a carry trade strategy:
- Uncertainty in exchange rates
- Interest rate risk
Uncertainty in exchange rates
The biggest risk in a currency carry trade is the uncertainty of exchange rates because the forex market is an exceptionally volatile one and can change its course at any point in time. While a positive carry trade on a currency pair that is appreciating can result in a substantial profit, adverse movement in the exchange rate of your currency pair can completely wipe out all the gains from the interest rate difference.
For this reason, use a carry trade strategy with caution because volatility in the market can have a fast and heavy effect on the currency pair you are trading. Without proper risk management, your position can take a heavy hit.
Interest rate risks
The second risk factor concerns the interest rates of the countries that own the currencies you’re trading. Interest rates are set by the respective country’s central bank and are subject to change. If the country of the investing currency reduces interest rates, or the country of the funding currency increases its interest rates, the positive interest rate difference will reduce or even completely wiped out, so you won’t be able to earn anything from the interest rate difference.
Of course, this can happen because a country with a low interest rate will soon experience a boost in economic activity through consumer spending, which will eventually lead to high inflation and a need to raise the interest rates. On the other hand, a country with a high interest rate may later need to reduce it to stimulate economic growth.
Tips for carry trade strategies
Here are some tips that can help you if you want to use a carry trade strategy:
- Find currencies with large interest rate differentials
- Go for stable currencies or look for upward trends
- Stay in as long as possible
- Use leverage to increase your profits
- Protect your downside risks with a stop loss order
Carry Trade Papers
Here is a paper from DB Currency Markets that dig deep into Currency Carry Trading. What are forward-rate-bias and forward premium puzzle and a lot more.