The technical of carry trade is one of the most known and used in the world of finance. Most institutionals and funds used it. Indeed, it is a simple way to make money.
The method is as follows: It consists of having debt in a currency with low interest rates and invests the funds borrowed in a currency whose interest rate is higher. It’s a way to take advantage of the gap between two interests rates of two different currencies, that is called interest rate differential.
The interest rate of the FED is currently at 0.5%. So you borrow dollar heavily to place these funds in an other currency which give you for example a profit of 4.5%/year. Your profit (Calculate your profit and losses) on the year is easy to calculate: 4.5% -0.5% = 4.0% You win 4.0% per year. It is the interest rate differential. This fact doesn’t make crazy … 4% is not enough for you, you can probably earn more by doing your small trades on the market … you’re right it is very possible but imagine now that you applied the technique of carry trade on the forex market, with its enormous potential of leverage … ahh, i sense you more concentrate!
Explanation: On the Forex, your broker gives you the ability to sell or buy all parities that you want. Therefore you can choose a parity with a large differential of interst rate. You just have to take position in the right direction and touch every night, at the close of the market, the interest rate differential.
This interest rate differential, you win or lose it every night when swaps are made. Your broker can give you the price swap, if they are not already displays on its website. You will just have to take position to receive the highest rate and pay the lowest.
The carry trade on the Forex : Notice
On the Forex market, we trade currency pairs, such as EUR/USD. When you’re buying Euro, you sell Dollar. You pay interest on the currency you are selling (USD), and collect interest on the money you are buying (EUR). Every evening, at the end of the day’s trading, brokers credit or debit to your account interest rates differential on all pairs which you are in position. That’s right the real advantage of the Forex to apply the technique of carry trade, every day your broker performs this calculation. Over the year, if the differential between the Euro and the Dollar is 4% for the Euro and you bought Euro, you will receive 4% of the amount invested. Well, not all true. Indeed, all the brokers apply commissions on swaps and you will not earn exactly the interest rate differential.
Of course, this is only in case which the price of EUR/USD has not changed over the year. The price is your entry price on the market when you bought the EUR. Very unusual! There are two other possibilities:
1. The price has fallen and your broker cut your position and in this case you lose your available margin. It remains you only your 1000E that allowed you to open your position. Ouch!!
2. The price has gone up in this case you win not only the interest rate differential (4000E) but you also take profit of a higher price. Jackpot!!!
This is for that reason that carry trade lead to a significant devaluation of the currency with low interest rates. Indeed, everyone sell the currency to the profit of currency with high interest rates to take advantage of the interest rate differential. This happened in a first step on the yen, whose rate was 0.50% to the profit of the euro and U.S. dollar, which had a high interest rate.
It is therefore important to choose the currency pair on which you want to make the carry trade. This must be coupled with a market analysis to determine which parity you see going in the side of your carry trade transaction.
As mention in the above example, the major risk of the carry trade is that the position goes in the wrong side according to the position taken(long or short).
The second risk on the carry trade is the evolution of interest rates on currencies traded. If it moves against you, you can lose a part of the interest rate differential which can highly affect your profit and even made you lose. Generally, when the differential is reduced following a rate change, it follows a massive sell or buy (depending on the side in which the carry trade was in favor), given the fact that all investors cut their position, trying to avoid being caught in the “snowball effect” (thereby contributing directly to the formation of this effect, actually …).
To illustrate, consider the example on the USD / JPY. As you know, the Bank of Japan always had rates close to 0. In contrast, the U.S. central bank had higher rates. So, everyone sold the yen to buy dollars. But, in mid 2007 when the suprime crisis occurred, the Fed began to cut rates. The carry trade transaction therefore became less and less interesting and gradually investors cut thei positions, which has also led to a fall of prices. The fall of prices leading itself investors to cut their carry trade position(The carry trade transaction was profitable if the price of USD / JPY rose).
The price decreased from 123 to 96 in less than a year. Misadventure to those who have held their position. Certainly, for a while they continued to receive swaps (the rate differential still existing) but the price decline caused them to lose lots of money!
To summarize, when rates do not move and there is no major event, the carry trade can be a very rewarding (swaps + spot rate which goes in your side). However, if an economic downturn lead to a change in interest rates, better react fast enough.
To apply the carry trade strategy by limiting your risk, that requires two conditions:
– Find an attractive interest rate differential
– Find a pair with a long term term which goes on the side of your operation of carry trade