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How does a Carry Trade work?

How does a Carry Trade work?
Asked by
Dennis Mayer categorie-icon time-icon4 months ago

Justin Freeman
Answered time-icon4 months ago

If you've been an investor for a while you've likely heard the termcarry trade. It isn't in vogue currently, but it has generated positive returns for many currency traders for decades since the 1980s. Until the 21st century began it was mostly used by institutional and professional traders, but the first decade of the 21st century saw individual investors begin to take advantage of the carry trade.

The carry trade was notablebecause it generated positive returns for more than 20 years, but in 2008 investors were reminded that what goes up can also come down. In a three month period roughly sevenyears’ worth of gains were erased.

The profits that were made from 2000-2007 have kept hopes alive among forex traders that the carry trade will return one day.

If you don't know about carry trades and are confused by the excitement generated by them among older currency traders, stick with me and I'll explain how the carry trade is structured, when it is successful, when not to use it, and some ways to apply the carry trade strategy.

What is a Carry Trade?

For a long time the carry trade was the most popular strategy in currency markets. Basically it involved nothing more than buying a currency with a high yield, while simultaneously selling a currency with a low yield. So simple, but also so profitable.

All of the most popular carry trades involved the Japanese Yen, since it had a yield of nearly 0%. The Australian dollar and New Zealand dollar both had quite high yields and were popular to pair with the Yen in carry trades.

So, there's the first step in creating a carry trade – find out the yield of various currencies and locate one with a high yield and one with a low yield.

As of November 2018 the yields of the largest of the world's currencies is as follows:

Australia (AUD)1.50%
New Zealand (NZD)1.75%
Eurozone (EUR)0.00%
Canada (CAD)1.75%
U.K. (GBP)0.75%
U.S. (USD)2.25%
Swiss franc (CHF)(0.75)%
Japanese yen (JPY)(0.10)%

Once you know these yields you can match the currencies with the highest and lowest yields to structure a carry trade. It's also wise to keep on top of changes, and planned changes, in interest rates since this will impact the carry trade.

With Japan and Switzerland both having an interest rate below 0% it's no surprise they would be shorted in a carry trade. And the U.S. Dollar is a good choice, since interest rates in the U.S. are already the highest of major economies and are expected to rise another 1% at minimum by the end of 2019.

In fact, the low yield of the Yen has even led to commodity and equity traders borrowing Yen to purchase various commodities, U.S. and Chinese stocks.

The Mechanics of the Carry Trade

The key to the carry trade is the ability to earn interest on the trade. This interest is paid on a daily basis and Wednesday's produce a triple interest payment to account for the Saturday and Sunday rollover. Here's how forex brokers calculate interest payments:

(Interest rate of long currency – Interest rate of shorted currency) * Notional of position / Number of days in a year = Daily interest earned.

For 1 lot of USD/JPY that has a notional of 100,000, we compute interest as follows:

(.0225 – (0.001)) x 100,000 / 365 = approximately $6.40 a day.

The amount won't work out to exactly $6.40 a day since brokers use the overnight rate from banks, which changes day to day.

Remember this interest is only earned if you're long the higher yielding currency. Some traders have been surprised to learn that when they are short in the higher yielding currency, they are required to pay the daily interest amount.

Carry Trade Benefits

The carry trade is not a day trading strategy. It is a long-term strategy. That makes it unique in forex since it is suited more for investors than traders. A solid carry trade does away with the need to constantly check price quotes. Carry traders have been known to hold positions for months, and in some cases even years. If you like to get paid for your patience, then the carry trade might be for you.

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