What is the “carry trade” and why is it relevant to FX trading?

Dec 4 • Between the lines • 6488 Views • 11 Comments on What is the “carry trade” and why is it relevant to FX trading?

shutterstock_114741433The carry trade is a fascinating phenomenon that FX retail traders should familiarize themselves with. Whilst it’s not necessarily a practice that retail traders can directly implement into the market through their trading, institutional traders (who employ the method to great effect) use the practice continually and as a result directly affect the retail trading market. As an activity it’s worth retail traders knowing how the carry trade ‘works’ as it widens their macroeconomic understanding of global events and FX movements.

Now the carry trade has enjoyed something of a renaissance over recent months and throughout the period where the USA Fed and ECB have kept their interest rates very low over recent years (circa 0.25-0.5%) whilst, for example, Australia’s and New Zealand’s base cash rates have remained fairly stable, at 2.5% for many months. This ‘stability’ offers up the ideal carry trade opportunities as it prevents a form of arbitrage.

A relatively simple description of the carry trade is probably applicable at this juncture

A carry trade is a strategy in which an investor borrows money at a low interest rate in order to invest in an asset that is likely to provide a higher return. This strategy is very common in our foreign exchange market. For example, over recent years many investors borrowed in Japanese yen or USD, taking advantage of very low interest rates in Japan and the USA and used the money to take long positions in currencies backed by high interest rates, such as the Australian and New Zealand dollars, South African rand, Brazil’s real and even India’s rupee.

For example, if hypothetically the British Pound (GBP) has a 5 percent interest rate and the US Dollar (USD) has a 2 percent interest rate, and you buy (or go long) on the GBP/USD, you are making a carry trade. Indirectly traders probably don’t realise it, but at times they’ll accidentally conducting a version of a carry trade. Perhaps they will use the Aussie (as their base currency) to buy the Aussie dollar versus the USD at the time the RBA announce their interest rate will stay the same (at 2.5%) and consequently out of step with that of the Fed in the USA at 0.25%. The Aussie rises as does the carry trade value.

This type of trading strategy relies on the relative stability in asset prices and as such relative stability and moreover predictability of interest rates. An adverse exchange rate movement can easily wipe out the returns from the underlying interest rate differential. For example, yen carry trade opportunities reversed sharply in 2007 as global interest rate differentials narrowed, causing the yen to rally versus currencies such as the Aussie and Kiwi dollars.

If institutional traders make an interest positive trade on a currency pair that pays high interest and the exchange rate stays the same or moves in their favour, they are a big winner. If the trade moves against them, the losses could be substantial. The daily interest payment to their account lessens their risk, but it is not likely that it will be enough to really protect from a trading loss. Carry interest should be viewed as the potential icing on the cake rather than just an easy trading strategy.

Like any other trading strategy, proper risk management needs to be implemented. It becomes tempting to reach out for that daily interest payment, but without some caution, that small payment could cost a fortune in losses. It is best to combine carry trading with supportive fundamentals and market sentiment. Carry trades work best when the market is in a positive mood. Properly executed carry trading can add substantially to overall returns.

Current Situation as an example of carry trade opportunities

Expectations that the Federal Reserve will keep its easy-money program in place into 2014 have created the perfect environment for a revival of the carry trade according to many foreign exchange strategists. Peter Rosenstreich, chief foreign exchange analyst at Swissquote Bank states;

We have conditions that are perfect. A low volatility and low interest rate environment. It means that currency traders are going to be looking for risk, high beta and interest rate differential trades.”

Strategists, however, warn that increased carry trade activity may not last beyond the next two quarters. The Fed’s supposed ‘taper’ has been delayed, so carry trades will become fashionable, but this may not be for a long time as the current fashion for carry trade is highly dependent on the Fed taper, which many economists and analysts believe is imminent. If money is kept ‘free and easy’, like it has been since 2009 when central banks started printing money through their QE and monetary easing/asset purchase schemes, then the opportunity ranks high for institutional traders. When money is longer free and easy institutional traders will then tend to look at valuations and not just a yield.

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