Currencies fluctuate in value every day, and the central banks that dictate monetary policy and interest rates play a primary role determining that value. The fluctuation of currencies against each other leaves room for exploitation by the enterprising trader, and in Forex trading, interest rate differences between countries can be leveraged for gain. “The objective of Forex carry traders is to catch the interest rate differential between two currencies and profit from the spoils”, says David Lojko, co-founder of Earn2Trade LLC.
What is a Carry Trade
In a carry trade, the strategy is to take a loan in currencies offering very low interest rates, like the Japanese Yen (JPY) or Swiss Franc (CHF), and then utilize these “funding currencies” for opening long positions in currencies backed by high rates of interest, such as the New Zealand Dollar (NZD) and the Australian Dollar (AUD). The interest acquired from these “carry currencies” is higher than the interest paid for borrowing the funding currency. That is why Forex pairs such as AUD/JPY or NZD/JPY are some of the most frequently traded around the globe.
This imbalance in the interest rates is known as a positive carry – and this is the profit that you can pocket by piggybacking on the differences in the global Forex market. So how does this look in practice? Let’s have a look at the nuts and bolts of a carry trade using the USD/CHF (Swissy) pair as an example.
The USD is in a strong position owing to an aggressive interest rate rally by the Federal Reserve. Interest rates are stacking up behind the Dollar, while the Swiss National Bank hasn’t felt the need to adjust interest rates since January 2015. Consequently, no central bank decisions are predicted to interfere with the trade in the next few months. When we look at the spread between the two currencies, we see that it was only 1.25% in 2016 but rose to 2.50% by mid-2018 and is expected to expand further this year.
The Swissy margin requirement is 5%, i.e., the leverage is 20:1, therefore with a $5,000 deposit on your account you can borrow $100,000.00 from the broker. A Swissy long position pays 0.71 pips per day. For a position with a $100,000.00 value, this comes out to CHF 7.10 (Swiss Francs) per day. If we decide to hold this position for 100 days, a CHF 710.00 profit is expected from the interest.
The CHF 710.00 converts to $700.00 at today’s rate. The 100-day interest earning is therefore 14% of the deposit (bearing in mind that the $5,000.00 deposit constitutes the basis of our profit vs. loss calculation). Thus, we see that a near three month period is sufficient to profit from interests significantly above the bank’s interest rates.
It sounds like an easy way to make money, however in real life simple and risk-free opportunities are mostly the subjects of daydreams, and complications are likely to arise from multiple sources. So let’s take a look at the most important commandments any carry trader should abide by to minimize their risks.
Thou shalt verify thy service provider
In order to handle and assess your risks appropriately, the first step is to review the website of the account management and trading platform provider. Examine the basic roll-over policy or overnight policy documents, which can usually be found on individual service providers’ homepages. This is important for clarifying limitations on your trade as well as to understand the rates and fees of your provider.
Thou shalt check thy numbers
The size of the trade can be determined according to two metrics: either in pips or in the selected currency. If calculating by pips, the quantity must be multiplied by the size of the position to determine the cash value. The value in the pip is always given in the quote currency (second currency in the pair). If calculating by currency, the ratio between the size of your position and the size of the position shown by the provider should be proportionate.
Thou shalt heed interest rate shifts
As the entire trading strategy depends on the relative difference in interest rates, any shift implemented by one of the eight important global central banks may turn the Forex market upside down. In the favorable scenario of a depreciation of the value of the lower-yielding currency you could leverage both the difference in the interest rates and the shift in the exchange rate to increase your profits. However, if the lower-yielding currency were to strengthen, in an extreme scenario you could end up losing money on your position. To reduce such risks, carry trades are usually set up between currencies with low volatility.
Despite the risks of trading with high volatility markets, traders are often motivated to seek positive carries outside of the major currency pairs if the developed markets do not yield big returns. In 2008 for example, it was common to see carry trades being taken between the JPY and Brazilian Real (BRL), or even the Turkish Lira (TRY).
Interest rates are a fluctuating variable upon which carry trades can generate a profitable return. The basic principle remains that if the prospects of the currency pair show a stable and favorable direction there is a good chance of a successful trade. However, one should always be aware of the risks involved, and that any profit model should calculate the possibility of dramatic exchange rates volatility.