If you’re fairly new to the Forex markets, you might not yet be familiar with the trading methodology known as the “carry trade.” It’s also known as interest-rate arbitrage.
The concept is simple. Borrow (sell) a currency from a country that charges low interest rates, and invest (buy) in a currency from a country which pays a high interest rate. That way, you earn the higher interest rate and pay the lower interest rate on your position.
This is one of the most common methods of making money in the world today. In fact, banks do it all the time. They pay a low interest rate on the money that they “borrow” (in the form of their customers’ deposits) and they reap a large rate on the money that they loan out.
Even if the difference in the two interest rates is only four or five percent, the leverage that is possible in a Forex account can make the potential returns extremely attractive.
For example, one of the most popular carry trade currencies over the past decade was the AUD/JPY. For many years now, the Japanese yen has been stuck at an essentially zero interest rate, while the Japanese economy has stagnated. And the Australian dollar, because of high inflation in the country, was paying in the neighborhood of 5%.
If you go long the AUD/JPY, which is essentially buying the AUD and selling the JPY simultaneously, you would earn approximately 5% per year. But leveraged to even a low 10%, suddenly that 5% becomes real money. And many Forex brokerages offer higher leverage than 10:1.
The danger, of course, is that the currency pairs do not remain static while you hold this position. The pair could move up or down, and a sharp move in the direction opposite your position will wipe out your gains quickly. Some people have referred to the carry trade as “picking up nickels in front of a steamroller” because of the nasty way that a carry trade can go bad suddenly.
So the key to a good carry trade strategy lies not only in evaluating the currency pairs for their interest differential, but also to determine how likely it is that the pair will move in the wrong direction of your trade.
The AUD/JPY carry trade was very popular for a long time because the Australian economy was stronger than the Japanese economy, and the pair trended upwards, which is the correct position for this carry trade. A look at a weekly chart of the pair will show that from 2009 through the beginning of 2010, this was an excellent strategy.
Not only did an investor earn the tremendous interest rate differential, but he also benefited from the capital gains he earned if he took some of the position off the table by closing some or all of the position.
For a great resource for information about the central bank interest rates in each country, check out the FXStreet.com World Interest Rates table. It covers the interest rates of 23 currencies, including the last time they were changed.
Today, the Aussie is yielding 3.25%, and the Yen is only .1%. That is still an attractive differential, and fine for a trade if you can only trade major pairs in your Forex account, but better pairs can be found now in the European currencies.
The Hungarian forint (HUF) yields 6.25%, and the Turkish Lira is yielding 5.75%. Depending on your broker, you may or may not be able to utilize these “exotic” currencies. However, if you can, they will probably be paired with the Euro, which is currently yielding 0.75%. (If you can get them paired with the USD, even better, since the USD now yields 0.25%.)
Your position for the EUR/HUFor the EUR/TRY must be short, not long, if you want to earn the interest differential. Fortunately for carry-traders, these pairs have been trending downwards as the Eurozone has struggled this year. So these pairs do have both of the criteria needed for a good carry trade: interest rate differential plus trend.
The key to the carry trade is not to be greedy, to be sure to leave plenty of margin for the pair to fluctuate without wiping out your account. It’s tempting to put all of your available cash into the position, but not smart. Calculate how much margin you would need to ride out a large swing, like 1000 pips, or even more, and be sure to always leave that much of a cushion in your account.
While in a carry trade, you also want to keep a closer eye on the economic fundamentals of your currencies than if you are trading using a technical analysis based trading method. Be aware of any major government policies or business shifts that could affect your countries’ economic situations, and be prepared to “unwind” your trade if things start to go in the wrong direction.
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