How to use the currency carry trade strategy

Board of currencies
By :  ,  Financial Writer

What is a carry trade?

A carry trade is a forex trading strategy that involves borrowing a low-yield (low interest rate) currency to buy a higher-yield (high interest rate) currency – to profit from the difference in interest rates. The Australian dollar/Japanese yen and New Zealand dollar/Japanese yen are popular forex carry trade pairs because of their high interest rate spreads. 

Interest rates are quoted as a yearly average but can change any day at the whims of central banks. However, some countries seek to maintain a low or high interest rate for an extended period in accordance with their economic policy, allowing traders time to profit using carry trades. Typically, a currency carry trade is kept open for several months.

At face value, currency carry trades may seem like a low-risk strategy, but there are pitfalls you should be aware of. For example, a minor depreciation of the target currency can be enough to quickly erase any gains from the interest rate differential. Carry trades are most effective when the currency pair you're using experiences low volatility.

How does a carry trade strategy work?

The carry trade strategy works by exploiting different rates of currency appreciation driven largely by inflation and interest rates. In a carry trade, you borrow a low-yield currency to buy a higher-yield currency, allowing your funds to appreciate faster than if they were denoted in the low-yield currency.

There are two main ways to execute a carry trade. The first is to use your borrowed currency to purchase other assets. In this case, you would borrow currency at a low-interest rate and invest it into another asset with a higher rate of return denoted in the higher-yield currency.

However, this potentially profitable strategy incurs additional risks with the use of other assets. So many traders use rollover rates instead, keeping their carry trade contained in the forex market.

How interest rates work in forex

Forex interest rates, also known as rollover rates, are charged as daily fees for holding your open positions overnight. These interest rates can be negative or positive, so they're important to consider in any forex trading strategy, not just carry trades.

Rollover rates are based on currency interest rates set by central banks. They tend to be stable during normal market conditions but can change drastically overnight if the interbank market becomes stressed or central banks decide to change rates. It’s useful to keep a calendar of central bank rate decisions on hand so you’re not caught off guard.

Rollover rates are executed at 5pm ET because the New York trading session is usually seen as the last, with the Sydney session ‘opening’ the next day. The forex market is open 24 hours a day, 5 days a week, closing at 4pm ET on Friday and opening again at 5pm ET. To account for the closed days, Wednesday’s rollover rate is tripled. 

Best carry trade pairs

The best currency pair for carry trades involve currency pairs with a high-interest rate base currency and low interest rate secondary currency. In this case, the secondary currencies are most important.

Two popular secondary currencies for positive carry trades are the Japanese yen (JPY) and the Swiss franc (CHF). Traders have more options when it comes to high-yield base currencies. Popular ones include the Australian dollar and the euro. Other currencies pairs that represent stable economies and low-risk countries include USD/CHF, USD/JPY, CAD/CHF, and NZD/CHF. These are all examples of currencies pairs with high interest rate spreads and stable economies.

How to make a carry trade

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Risks of carry trades

Because carry trades rely heavily on interest-rate spreads between two currencies, any change made to either currency’s interest rate by that country’s central bank can drastically affect your trade. Additionally, if the currency pair’s exchange rate moves against you during your trade, all your profits from the interest rate differential may be wiped out when you close the position.

For example, the Japanese yen is a popular funding currency for carry trades because the country seeks to maintain near-zero interest rates. But during the credit crisis of 2008, interest rates for high-yield currencies like the euro and US dollar were slashed. Japanese investors rushed to pull out of overseas investments and reinvest in the yen, causing the currency to appreciate and carry trades involving the yen to unwind as the interest differential between currencies became insignificant or reversed.

Benefits of carry trades

Carry trades have several advantages beyond the addition of interest earnings on top of your trading gains. The interest payments made by your broker are on the leveraged amount, so if you open a trade for one lot (100,000) you may only need $2000 depending on your broker’s margin requirements. However, the interest paid by your broker is on the entire $100,000, not just the $2000 of your own funds.

Carry trading can return regular profits when markets stay relatively stable, which makes it a popular strategy during times of low volatility. However, as with any forex trade comprehensive risk management is essential—so make sure you have your stop-loss and take-profit orders set up before entering the position.

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