2023.03.07 2023.03.07
What is Carry Trade and How does It Work in Today’s Economy?Oleg Tkachenkohttps://www.litefinance.org/blog/authors/oleg-tkachenko/
The Carry Trade strategy was invented in the 80s after the Jamaican system introduced exchange rates movements. The essence of this trading strategy is to buy the currency of a country with a low interest rate and invest in assets with a higher return on investments – currencies with a high carry interest rate, securities, etc.
After reading this article, you will know what the Carry Trade strategy is and what its advantages are. Learn how to use it to make money on the foreign exchange market, all the while minimizing the risks typical for this trading strategy.
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What is Carry Trade? Definition & Meaning
Carry Trade in simple terms is when a person borrows a cheap resource in order to buy an expensive one. Their trading gains are the interest differential between the yield of the expensive resource and the loan payment.
Example of a carry trade: The S&P500 returns 30% per year. You take a loan from a bank at 10% per annum and invest in futures, earning 20% of net trading gains. Of course, the index’s stable yield of 30% over the past three years does not guarantee that it will continue. If at the end of the year the index yields less than 10%, you will incur a loss.
As an alternative to the S&P500 index, you can invest in a less risky asset that has a guaranteed return. Investors often choose government bonds for these purposes. But the rate of return for the bonds of individual countries is 2-3%, so the investor needs to find the cheapest possible way to borrow money.
The effectiveness of the carry trade strategy depends on several factors:
Loan rate. The higher it is, the higher should be the return on the asset in which this borrowed money will be invested.
Carry trade profitability. It should be enough to cover the costs of the loan and support of the transaction. The yield can be fixed, for example, on bonds, or floating, growing relative to the purchase price of a stock quote.
Volatility of the investment asset. High return means high risk. Therefore, with high volatility, an investor can get both excess interest earnings and a loss. If they choose volatile assets, they need to constantly monitor market sentiment to quickly sell quotes in the event of a price reversal.
Important! The Carry trading strategy does not in any way limit the trader in choosing a country or an asset. In theory, they can take a loan from a bank in one country and invest in an asset in another. But the intended purpose of borrowed money, losses on conversion, transaction servicing and commission make this not worth it. Therefore, in most cases of carry trades, such transactions are carried out by private traders on exchange and over-the-counter markets, on electronic platforms.
Main Components of Carry Trade
The main components of gaining interest earnings with the Carry Trade strategy:
Key carry interest rate of the central bank. This is the rate at which central banks lend to commercial banks. They, in turn, set deposit and lending interest rates. The discount rate reflects the value of money. With the rate unchanged, the trader’s profit or loss reflects the interest differential between them.
Exchange rate change. If it grows, the investor gets a profit in addition to the difference in discount rates.
The goal of Carry Trade on the Forex currency trading market is to open a sell position in the currency with a low interest rate and a buy position in the currency with a higher interest rate. Let’s consider an example of the Japanese yen carry trade (JPY is historically a popular example of funding currency in carry trades due to being a low interest rate currency). For example, when opening a long position in the AUDJPY pair, a trader buys the Australian dollar for borrowed money in the Japanese yen. To make a profit from the yen carry trade, the JPY key interest rate must be lower than the AUD rate.
Let’s consider Carry Trade trading on the Fx market with currency pairs using specific examples.
How does the Currency Carry Trade Work? Explained with Real Examples
The key principle of carry trade in Forex currency trading is to borrow a less expensive currency and use it to buy a more expensive one, thus earning interest income. Example:
In the AUDJPY pair, the JPY is a low interest rate currency with a discount rate of 1%, the AUD discount rate is 4%. In order to buy the Australian dollar for the Japanese yen, a yen carry trader must borrow it — open a short position with this funding currency.
The trader opens a long position in the pair AUDJPY carry trade.
A year later, the trader receives +4% for investing in the AUD and pays 1% for using the JPY. The trader’s net profit from this currency carry trade, provided that the AUDJPY rate has not changed over the year, is 3%.
What happens if the AUDJPY goes up? For convenience, let’s take an interest rate of 1:2.
The investor borrows 100 JPY at 1% to buy currency in the amount of 50 AUD.
Other investors follow the same currency carry trade strategy. The rapid growth in demand for the AUD leads to an increase in its price up to 1:3.
A year later, the investor receives 3% profit from this currency carry trade due to the difference in discount interest rates. And they sell 50 AUD for 150 JPY. 100 JPY goes to repay the loan, 50 JPY is the investor’s net profit in addition to carry trading.
In practice, this mechanism is implemented by accruing swaps when transactions are rolled over to the next day. When opening AUDJPY yen carry trade, the broker actually sells JPY to the trader and buys AUD at their expense. At the same time, the yen carry trader pays interest on the sold currency and receives it on the purchased currency. And this percentage is tied to discount rates. At the end of the day, the carry trade broker recalculates all positions, taking into account its commission.
What you need to know about swap in Forex trading:
Swap is a fee for rolling an open position over to the next trading session in accordance with the contract specification. If the swap is positive — the trader is credited with the difference between the discount rates, taking into account the trading conditions of the broker. Negative swap is written off.
The swap is different for each currency pair (asset) and is set by the broker based on the interest rate differentials.
Swaps for long and short positions are different.
The swap value is set in the specification in the trading conditions of the broker or on the trading platform.
The value of the swap should be taken into account in the calculation of potential profit, regardless of whether the strategy used is carry trade or earning on the difference in rates.
Carry Trade Examples
The number of currency pairs with a positive swap (set on the base of interest rate differential) is relatively small. The choice is complicated by the instability of the largest differences in discount rates — countries with high rates can lower them so as not to restrain the development of the global economy, but countries with low interest rates, on the contrary, can raise them. Therefore, it makes sense to chase not so much a high interest rate difference, but rather the stability of the interest rate and the direction of the trend.
Important! Swap can be used for both long and short positions. Two points are important:
Only open a position in the direction of the positive swap.
In order for a positive swap not to be negated by the foreign exchange loss, the rate must be in flat or higher/lower for a long/short position. The longer it stays in this state, the more the trader will earn on the daily accrual. This issue is solved in part by setting a stop loss at the breakeven level.
Let’s look at a few examples of applying the Carry Trade strategy in the foreign exchange market:
1. EURMXN
For this pair, the positive swap is for a short position: the discount interest rate for the country’s quoted currency (Mexican peso, MXN) is higher than for the base currency (EUR). Therefore, it is more profitable to sell the euro and buy the peso.
The long-term carry trade offers great potential trading opportunities – there are protracted sections of a downtrend. And if the carry trade position is insured with a stop order, a sharp increase in quotes is not a problem.
2. USDZAR
Another pair relatively suitable for short positions. Despite the high volatility, there are clear downtrends on long timeframes.
Currency pairs with RUB (EURRUB, USDRUB) were the most attractive asset for Carry Trade in 2021, overtaking the Argentine and Mexican pesos in terms of prospects. But due to the high volatility of 2022, the periodic strengthening and weakening of the ruble, it is not recommended to work with this currency using carry trade strategy at the moment.
Another unsuitable pair is USDTRY. It has a positive swap on short positions, but there is an uptrend. It is possible to catch a downward movement on short intervals, but the potential profit is not worth the spread and time.
Important! These examples show the principle of choosing a currency pair and finding a suitable chart for the strategy. If interest rate differential changes, swaps will change, and hence the attractiveness of certain currencies for carry trading.
Leverage Carry Trade Examples
Leverage carry trade strategy has a serious drawback – its relatively low carry trade profitability. To calculate the potential profit, this formula is used:
Profit = point value × swap × number of days
Point value is its price in monetary terms. It depends on the currency pair and the volume of the trade. You can read more about calculating the value of a point in the review “What is a Forex currency trading lot and how to calculate it”.
Swap is for the swap size set in the specification.
Number of days is the duration of holding a trade in the market. Swap is charged on an open position at the end of each day, triple for weekends.
Example. Input data for the currency pair: point value — 0.01 USD for a trade volume of 0.01 lots and 5-digit quotes, swap — 1.156. The total profit of a trader on a position with a minimum volume for 1 day will be 1.156 × 0.01 = 0.01156 USD.
A trader can hold the position for a year. If discount rates remain unchanged, they can earn 0.01156 × 365 = 4.2194 USD on this trade. But a trader can also use leverage – borrowed money from a broker, which will increase the volume of the trade. For example, a leverage of 1:100 allows you to open a trade with a volume of 0.01 × 100 = 1 lot. Accordingly, the cost of a point will increase by the same amount — up to 1 USD. Annual earnings implementing leveraged carry trade will be almost 422 USD.
Note! A decrease in the key rate on the investment currency will lead to a decrease in profitability. Thus, before using leverage it’s advised to conduct thorough financial planning.
Positive Carry Trade
Positive Carry trading is a strategy for making money on the difference in discount rates. An investor borrows a currency of tfhe country with low interest and buys a currency with a higher interest discount rate. At the end of a fixed period, they make a profit in the form of the difference between them. Carry trades work for currency pairs with a positive long or short swap. The value of a positive swap on Fx means that at the end of the trading session, the profit is credited to the trader’s balance.
Contract specifications can also be found in the client’s cabinet in the “Instrument information” section.
Negative Carry Trade
Negative Carry Trade is when the cost of owning an asset is greater than its return. This means that investments are unprofitable as long as their basic value remains unchanged or falls. In Forex trading, a negative swap translates into additional costs. It is not charged if the trade is closed intraday and is automatically charged when an open trade rolls over to the next trading session.
Why Carry Trading is so Popular?
The popularity of carry trade is somewhat exaggerated. There are a few reasons:
Small income. Private traders who try to avoid risks operate with amounts up to 1,000 USD. Based on the risk, it is possible to calculate the allowable volume per trade, and hence the point value. Knowing the point value, you will calculate the swap profit. This profit, taking into account the risk and the time spent, is rarely worth it.
The risks of leveraged carry trades. With leverage, an investor’s return from carry trade on a long timeframe seems tangible, but this is illusory. In order to make a profit, the rate should under no circumstances go below the leveraged carry trade opening level, which is rare on a long timeframe. If the rate goes down, you need to understand what the point value with the maximum leverage is. And how large of a deposit you need to have so that the trade is not closed by stop-out. And if you have such a deposit, does it make sense to freeze it for the sake of a carry trade? Note that leverage always requires robust financial planning.
Small selection of assets. There are relatively few currency pairs with a positive swap. If we weigh all the pros and cons, it turns out that it is faster to make money on fundamental volatility, for example, the EURUSD pair, than to focus on the cross rate and build a separate trading system for it on daily timeframes.
Carry Trade is a strategy that is complementary to the main speculative operations. If the swap is negative and there is an opportunity to earn on the difference in rates, it shouldn’t be a reason for abandoning the strategy. If the swap is positive, the additional profit is a plus.
What Risks are Involved
Forex trading risks using the Carry Trade strategy:
Price going in the opposite direction to the opening of the trade. You opened a long position, but the price of the currency pair immediately went down – the trade was closed by a stop out. You made money on the swap but lost on the spread and rate difference.
The currency risk is neutralized if the price moves in the direction of the trade and the stop loss is moved to the breakeven level.
Change in discount rates. With their help, central banks adjust the inflation rate. Therefore, in developing countries with unstable economies, discount rates can change frequently by a lot, and not always in favor of the trader. Examples of factors affecting rates and market sentiment: financial crises and the state of the global economy, domestic monetary policy to maintain the stability of the national currency, the economic activity of the largest financial market players, etc.
The risk is offset by constant monitoring of fundamental factors that affect the discount rate.
To minimize risks, I recommend diversification. For example, a combination of the most and least profitable pairs. The most profitable pairs have a larger interest rate differential, but also a higher risk that a country with an investment currency can cut it to stimulate the economy. You will learn more about risk management methods in the review “Risk management in trading for experienced and novice traders”.
Pros and Cons of Carry Trading Today
Algorithm for searching for currency pairs with a positive swap in MT4:
1. Open the table of discount rates of banks. You can find it, for example, on the analytical portal Investing. In the table, pay attention to the pairs with the largest difference in discount rates.
A few important points:
It is best if the list covers as many countries as possible. The list of Central Bank rates on Investing is not complete, but it is the most convenient example.
For a long position, the base currency must have higher interest rate than the quoted one. The base currency is the first, the quote currency is the second. This condition will not guarantee a positive swap, but will speed up finding the right pair. For a short position, the condition is reversed – the discount rate for the quoted currency must be higher.
The pair composed according to this principle must be among the broker’s trading instruments. Cross rates often suit the requirements, but not all brokers have them.
The classic pair USDCHF fits the given conditions. The USD rate is “0.5%”, higher than that of CHF – “-0.75%”.
In MT4 do the following:
In this case, the swap for long positions is greater than zero. You can buy it.
Note! The difference in discount rates between the base and quote currencies in favor of the base does not guarantee a positive swap. Let’s look at the GBPCHF currency pair. For the British pound, the discount rate is even higher than for the USD in the previous example, but the swap here is negative.
Advantages and Disadvantages of Carry Trading
The below table shows the pros and cons of carry trading:
Pros of Carry Trading
Cons of Carry Trading
Moderate risks:
The exchange rate risk is capped by a stop loss order at breakeven
Small swap size:
To get a tangible profit, you need to keep the position on the market for weeks. Leverage is used to increase the point value, but it also increases the risks if the stop loss is not set at the breakeven level.
Passive income:
Positive swap is credited every day as long as discount rates remain unchanged
Limited selection of assets:
Only assets with a positive swap can be used
Strategy for Carry Trade in Forex
Finding a currency pair with a positive swap is a matter of minutes, you just need to review the specifications in the trading platform. But this still does not guarantee you any profit. Let me remind you that buying an asset with a positive swap for long positions will be unprofitable if the rate goes down – the positive swap will not pay off the difference in quotes. Therefore, I recommend to adhere to the following tactics:
Step 1. Choose a currency
Compare the discount rates of the Central Banks, look at the specifications and look for a positive swap. Let’s suppose you’ve found a currency pair with a positive long position swap.
Step 2. Analyzing the news (fundamental analysis)
You need to analyze the factors and market sentiment affecting the rate (financial crisis, monetary policies, etc.) and make sure that the rate in your open position does not reverse in the opposite direction. In other words, the movement of quotes should make it possible to earn not only on their difference, but also on a positive swap. And it is important to take fundamental factors into account.
Step 3. Analyzing the chart (technical analysis)
The difference in discount rates in the short run is negligible. So you have two options:
In order for you to make money on a carry trade, the trend must be going in the right direction, or at least sideways. Ideally, with a positive long position swap, you need to catch the beginning of an uptrend on the D1-MN timeframe.
Trend indicators that will help you find the beginning of a long-term trend:
Moving averages. All versions of moving averages show the direction of the long-term trend quite well. Read more about them in the review “Moving Average: How to Use the EMA Indicator”.
Alligator. This is a basic indicator by Bill Williams for MT4 and MT5, consisting of three moving averages with different periods and shift parameters. The simultaneous divergence of moving averages indicates the beginning of a trend. Read more about it in the review “Alligator by Bill Williams”.
Momentum. A leading indicator that allows you to measure the amount of change in the price of a financial instrument over a certain period of time. “The Momentum Indicator: A Complete Guide with Charts and Examples”.
Additionally, you can use confirming oscillators to help identify the moments of trend reversal.
Step 4. Looking for market exit points
The amount of profit of a positive swap does not depend on the dynamics of the trend, only its direction is important. But if you have already caught an uptrend, the best option is to get as much profit as possible from it by closing the position at the time of the reversal. But in any case, the position will close in profit if you set a stop loss at the level of “trade opening point + spread”.
Summary
Key takeaways from the Forex carry interest trade strategy:
The essence of the strategy is to open a short or long position in an asset with a positive swap. You can find the swap value in the specifications.
In accordance with the strategy, you can only get profit when the rate goes in the direction of the position or is in a flat. If the rate goes in the opposite direction, the loss will exceed the profit from the swap. Therefore, with a long-term strategy, it is important to have time to adjust the stop loss to a level that guarantees no loss.
A positive swap is credited every day, a negative swap is deducted.
Pairs with high volatility are not suitable for the strategy due to the risk of losses on the difference in rates.
A high rate on the investment currency is not always good, since there is a possibility that the central bank will lower it to revive the economy.
Swap income with a minimum trade volume for several days amounts to mere cents. A trader can use margin trading, thus increasing the risks, or increase the volume of the deposit and, accordingly, the position, all the while freezing the money for a long time. Carry trade is not suitable for intraday trading. The analysis should be carried out on weekly and monthly timeframes.
The strategy is suitable for traders as an additional income to exchange rate movements trading, as well as passive investors with large capital. You determine the amount of capital yourself, based on your profit targets.
Carry trade seems to be a relatively risk-free strategy, but an entry error can cost you most of your deposit.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.
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