Carry trade is a popular trading strategy in the foreign exchange (forex) market that involves borrowing a currency with a low interest rate and using it to purchase a currency that offers a higher interest rate. The trader attempts to capture the difference between the rates, which can often be substantial. When done correctly, carry trading allows traders to make steady profits with relatively low risk. However, there are some nuances to executing successful carry trades. This comprehensive guide will explain what carry trade is, how it works, tips for implementing it, and the risks involved.

What is Carry Trade?

Carry trade refers to a strategy where a trader borrows funds from a country with low interest rates, converts it to the currency of a country that pays high interest rates and invests it in high yield assets.

For example, you can borrow Japanese Yen at 0.1% and then convert it to Australian Dollars which pay 1% interest. By doing this, you can earn the interest rate differential of 0.9% which is calculated as (1% – 0.1%).

The interest rate differential between the two currencies is known as the carry. The currency with the higher interest rate is called the carry currency while the lower interest rate currency is called the funding currency.

Carry trading aims to capture the carry or interest rate differential between currencies. It involves being long the carry pair i.e. long the currency pair involving the carry and funding currencies. The carry represents the extra return that a trader gets from going long the carry pair.

How Does Carry Trade Work?

Here are the typical steps to execute a basic carry trade strategy:

  1. Identify a currency pair with a positive interest rate differential e.g. AUD/JPY. The Aussie Dollar (AUD) is the carry currency as it has a higher interest rate while the Japanese Yen (JPY) is the funding currency.
  2. Open a long position in the carry pair i.e. buy AUD/JPY.
  3. Fund the trade by shorting or borrowing the funding currency i.e. short JPY. This borrowed JPY is converted to AUD at the spot exchange rate to fund the long AUD position.
  4. The AUD interest received is higher than the JPY funding cost. This interest rate differential or carry is captured as profit.
  5. Close the trade by selling AUD/JPY and repaying the borrowed JPY funding amount. Include the interest differential in the net profit calculation.

As long as the currency pair doesn’t move against the carry trade such that it offsets the interest rate differential, the trader will make a profit. Even if the carry pair remains stable or doesn’t move at all, the trade will still capture the carry.

Why is it Called Carry Trade?

The term carry comes from the fact that the trader is carrying the higher interest rate currency. By being long the carry currency, the trader carries the extra interest income.

Carry trade gets its name from this interest rate carry or differential that the trader aims to capture. Other associated terms are positive carry and negative carry.

When the interest rate differential is positive i.e. the carry currency has a higher interest rate, it is called positive carry. When the funding currency has a higher interest rate, it leads to negative carry.

Traders prefer pairs that have positive carry as it results in interest income. Pairs with negative carry involve interest expenses and are avoided.

Advantages of Carry Trade

Here are some of the major benefits of using a carry trade strategy:

  • Consistent returns – Carry trade offers the opportunity to make steady profits month after month provided the rate differential persists. The gains come from the predictable interest rate differentials rather than speculation on the price direction.
  • Low risk – Carry trades benefit from low volatility in the currency markets. The goal is to harvest the interest yield and not capital gains. As long as the currency pair doesn’t make huge moves, the interest differential acts as a buffer against regular fluctuations.
  • High leverage – Carry trades allow the use of a high degree of leverage to amplify returns. Leverage of 100:1 or even higher can be used to maximize interest income. However, leverage also increases risk.
  • Diversification – Carry trades provide diversification as returns come from interest yield and not price action. It acts as a good hedge against other trading strategies that depend on capital appreciation.
  • No advanced skills needed – Carry trade relies more on interest rate differentials which are fixed. It doesn’t require making predictions on future price trends. The strategy is simple to understand even for novice traders.

What Currency Pairs are Best for Carry Trade?

The key to successful carry trading is choosing pairs with the highest interest rate differential. Here are some popular carry pairs:

  • AUD/JPY – This is one of the classic carry trade pairs. The Reserve Bank of Australia typically maintains higher interest rates than the Bank of Japan. The current interest rate differential is around 4.5%.
  • NZD/JPY – Similar to AUD/JPY, this pair exploits the low JPY funding costs. The RBNZ also keeps rates higher than BOJ. The average carry is approximately 4%.
  • EUR/CHF – The Euro tends to have higher interest rates than the Swiss Franc which has rates close to zero due to the SNB’s interventions. The carry can reach up to 2.5%.
  • GBP/CHF – The British Pound also mostly has higher interest rates than the Swiss Franc making GBP/CHF a good carry pair. The interest rate spread is around 1.5%.
  • EUR/JPY – The Japanese Yen is popular as a funding currency. EUR/JPY enjoys carry in the range of 2.5% facilitated by the BOJ???s low rate policies.

When choosing pairs, focus on the interest rate differentials over the long term. Temporarily high or low rates may reverse in due course.

Tips for Successful Carry Trade Execution

Here are some tips that can help improve your odds of executing profitable carry trades:

  • Choose pairs with highest interest rate spread – Look for currency pairs offering the biggest rate differentials for the maximum carry. Avoid pairs where the difference is negligible.
  • Use high leverage judiciously – Leverage can amplify returns but also increases risks exponentially. Use only as much leverage as your account can withstand if the trade moves against you.
  • Keep long term positions – Hold carry trades open for months or years, not days and weeks. This allows enough time to harvest the interest income.
  • Use stop losses – Use stop losses to contain potential losses if the currency pair moves sharply against your position. Tight stops defeat the purpose of carry trades. Give it room to fluctuate.
  • ** Watch for interest rate changes** – If a central bank changes interest rates, it can turn positive carry to negative carry and vice versa. Adjust your pairs accordingly.
  • Manage liquidity risks – Exotic currency pairs may provide higher carry but have wider spreads and less liquidity. Stick to major pairs like EUR/JPY unless you can absorb the higher costs.
  • Diversify – Carry trade with multiple pairs and not just one pair to spread the risk across various currencies. Diversification improves chances of success.

The Risks of Carry Trade

While carry trading has several advantages, it also involves the following risks:

  • Currency volatility – A sharp move against the carry trade can generate losses that exceed the collected interest income. This may force you to close the position prematurely.
  • Black swan events – Carry trades are susceptible to tail risks or unexpected events like natural disasters, market crashes, geopolitical turmoil etc. These ???black swans??? can cause deep losses.
  • Interest rate changes – An unexpected rate cut by a central bank can turn a profitable carry trade into a loss making one instantly.
  • Over-leveraging – The use of excess leverage in order to amplify profits can be disastrous if the carry pair moves against you.
  • Liquidations – Banks and brokers may liquidate carry trades at short notice if account equity falls below margin requirements. This can lead to forced exit at unfavourable prices.
  • Widening spreads – Exotic currency pairs are vulnerable to widening spreads which increases transaction costs and lowers effective interest rate differentials.
  • Internationalization of rates – Central banks are increasingly coordinating interest rate policies which may reduce spreads and carry trading opportunities.

Historical Examples of Carry Trade Unwinding

Here are some instances from the past where carry trades suffered severe losses and mass unwinding:

Yen carry trade unwinding (2007-2008) – Carry trades funded in cheap Japanese Yen got massively unwound after the Global Financial Crisis caused unexpected losses. The tumbling stock markets prompted traders to deleverage carry positions. The repatriation of Yen caused it to appreciate sharply.

Swiss franc turmoil (2015) – The Swiss National Bank abandoned the Euro peg for the Swiss Franc which caused it to rise exponentially. This inflicted huge losses on EUR/CHF and CHF/JPY carry trades over a single day. Traders lost millions within minutes as the move was completely unexpected.

Dollar carry unwind (2018) – Rising interest rates in the U.S. prompted mass scale unwinding of Dollar funded carry trades. Pairs like AUD/USD and NZD/USD fell as the safe haven Dollar rallied on the rate hikes. Traders faced margin calls as the Dollar appreciated.

The common theme is that unexpected moves arising out of surprises and crises can rapidly reverse carry trades and cause severe losses due to overleveraged positions. It’s critical to be aware of these risks.

Carry Trade Strategy Variations

Here are some variations of the basic carry trade strategy to further optimize returns:

  • Interest rollover – Instead of closing the entire carry trade, just roll over the interest portion into the next period. This crystallizes partial profits periodically while keeping the core position intact.
  • Hedged carry – Hedge carry trades with instruments like options to limit potential losses. Hedging reduces the risk if the carry pair moves against you sharply.
  • Leveraged carry – Use very high leverage between 50:1 to 200:1 to amplify interest rate differential gains. Only recommended for experienced traders.
  • Mixed carry portfolio – Diversify across multiple carry pairs carefully selected based on highest positive interest rate differentials.
  • FX swap for funding – Use FX swap markets to borrow funding currency instead of shorting it in the spot and borrowing rates in the swap markets.

Conclusion

Carry trading offers a way for forex traders to generate steady returns by exploiting differences in global interest rates. It provides attractive income in a low risk manner compared to other currency trading strategies. However, traders need to be cautious with leverage and understand vulnerabilities inherent in carry trades. By following sound risk management practices and the tips outlined in this guide, you can judiciously incorporate carry trade into a well diversified forex trading portfolio.