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Picture this: a trading strategy that can potentially generate profits even when prices move in a consolidation over extended periods.
Sounds too good to be true?
Well, it's not only true but also hailed as one of the most popular trading strategies of hedge fund managers – known as the carry trade strategy.
In this article, we will delve deeper into the intriguing intricacies of the carry trade, exploring what is carry trade, its workings, risk factors, and real-world examples.
What is Carry Trade?
At its core, a carry trade involves a clever maneuver: an investor borrows money in one currency, taking advantage of its low-interest rate, and then strategically invests it in another currency boasting a higher interest rate.
Source: Statista – World Major Central Bank Interest Rate Policy
The magic lies in the return generated, which is akin to the difference between these two interest rates.
Essentially, a carry trade enables investors to earn returns merely by holding or "carrying" the higher-interest currency over a long period. The FX carry trade strategy's success isn't dependent on the currency's appreciation, although that can boost the potential profits of this trading strategy.
In the realm of carry trade, investors skillfully borrow in a low-interest-rate currency and allocate their funds towards acquiring a currency or asset that fetches a higher interest rate seeking to capitalize on the interest rate differentials.
Now that we covered the carry trade definition let’s look at some real-world examples.
What Is an Example Of a Carry Trade?
Allow us to paint a vivid picture of a carry trade example that showcases the brilliance of a carry trade. Imagine you're in the world of Forex trading, where currencies dance and interest rates play a crucial role in shaping trading opportunities.
Currently, the US dollar (USD) is offering an attractive interest rate of 5.5%, while the Japanese Yen (JPY) lags at a -0.1% interest rate. Now, you decide to take advantage of this interest rate differential between the Fed and the BOJ and make a savvy move by going long on the USD/JPY pair – congratulations, you've just initiated a carry trade!
Source: TradingEconomics US vs. Japan interest rates
Here's how it works:
Every day that your USD/JPY trade is active, your broker will pay you the difference between the interest rates of these two currencies, which, in this case, amounts to a delightful 3% – this is also known as the swap rate or the Forex rollover rate.
Though it might not sound monumental daily, such interest rate disparities can gradually accumulate and turn into a noteworthy source of profit over time.
This example highlights even better what a carry trade is.
Carry Trade Example From Real World
To illustrate this concept further, let's dive into a tangible scenario. Picture yourself walking into a bank and borrowing $50,000. The bank kindly charges you a lending fee of 2% of the borrowed amount annually.
Armed with this borrowed capital, you shrewdly invest in a $50,000 bond that promises an enticing 4% return each year.
Now, the moment of truth arrives:
What's your carry trade profit?
The answer is a resounding 2% a year – the difference between the interest rates. Simple yet effective, isn't it?
You might be thinking, "Well, that doesn't seem as exhilarating or profitable as catching intraday market swings."
And you're not entirely wrong. However, when this powerful carry trade strategy is applied to the dynamic spot forex market, with its higher leverage and daily interest payments, the thrill of watching your account grow day by day becomes a truly exciting venture.
What is The Best Carry Trade?
In 2023, the world's favorite carry trade involves traders borrowing Japanese yen (JPY) or Swiss Franc (CHF) from central banks that have set interest rates at historic lows. These funds are then deftly converted into the US Dollar (USD) to seize the opportunity of investing in much higher-yielding bonds. It comes as no surprise that going long on USD/JPY and USD/CHF is a blazing hot carry trade of the year.
Source: TradingView – USD/JPY – Carry Trade of 2023
For those seeking enticing targets in emerging markets (EM), the Brazilian real and Mexican peso take the spotlight, which are high-yielding currencies fetching a whopping 13.75% and 11.25% respectively, as of August 1, 2023.
It's no wonder that seasoned investors are eyeing these alluring options as potential gems in their carry trade endeavors.
Now, rewinding to pre-COVID times, a different narrative shaped the landscape of foreign currency carry trades.
During the era of low-interest-rate policies, the Australian dollar (AUD) and the New Zealand dollar (NZD) reigned supreme as the chosen companions for the Japanese yen (JPY). This match was made in financial heaven due to their impressive interest-rate spreads. The savvy move of borrowing in Japanese yen and investing in Australian or New Zealand dollars became a common and successful carry trade strategy.
Is Carry Trade Profitable?
The carry trade strategy is profitable as long as it abides by its golden rules to first buy a high-yielding currency and fund it using a lower-yield currency.
But here's the catch – the success of the carry trade isn't solely dependent on the interest rate differentials. One must keep a keen eye on the fluctuations in currency values. The ultimate test lies in ensuring that the additional interest gained from the high-yield currency is not overshadowed by the depreciation of that very currency.
To put it simply, the value of the high-yield currency should not drop significantly more than the interest it earns.
As with any Forex trading strategy, timing and approach play a vital role. Day trading and scalping strategies may not be the best fit for carry trade FX, as these fast-paced maneuvers leave little room for overnight holds. Instead, swing trading and position trading take center stage as better-suited strategies for carry trades.
With these longer-term approaches, the trades can be carried overnight, giving them ample time to unfold and potentially realize their full profit potential.
Is Carry Trade Risky?
The carry trading strategy, while alluring, does not come without its fair share of risk:
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Volatility risks.
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Changes in interest rates.
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Carry trade unwind phenomenon.
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Borrowed currencies can also be appreciated.
For instance, emerging markets boast alluring higher interest rates that might seem like a tempting proposition, but these same markets carry heavy political risks. Such uncertainties can trigger sudden currency volatility or unexpected depreciation, potentially leading to severe losses in the realm of Forex carry trading.
It's important to acknowledge that emerging-market currencies, in particular, tend to be more volatile, and the magnitude of their upheaval can surpass that experienced in well-established developed markets.
The carry trade unwind phenomenon is also a big currency risk that happens when a global capitulation out of a carry trade ensues, causing the "funding currency" to surge in strength rapidly. To protect themselves from risk-averse movements, traders should hedge some of their market exposure.
An illuminating example lies in the tale of the unwinding of the YEN carry trade in 2007, The carry trade Forex strategy had swelled to an astonishing $1 trillion, lured by the allure of near-zero interest rates in Japan.
But the winds of change swept over the global economy in the chilling wake of the 2008 financial crisis. The calamitous collapse of virtually all asset prices set in motion the dreaded carry trade unwind. As the crisis intensified, traders scrambled to untangle their carry trades, seeking refuge from the stormy market conditions.
In the face of this upheaval, the yen strengthened by 29% against various currencies in the tumultuous year of 2008. The U.S. dollar, another victim of the storm, experienced a sizable 19% decline against the carry trade by 2009.
Now that you know what is carry trade, explore our best Forex brokers comparison table now and find the perfect broker with competitive swap rates. With the right broker by your side, you'll gain access to a world of high-yielding currencies and the tools you need to execute successful carry trades.
