A carry trade is a currency transaction where you would borrow one currency and use that money to purchase another. You would pay a low-interest rate on the borrowed currency while collecting a high-interest rate on the base currency. The profit is the difference in interest rates between the two currencies.
Currency traders might use carry trading as an alternative to the stock market strategy of buying low and selling high, which is difficult to perform daily. The most common carry trade pairs include the Australian dollar and Japanese yen, as well as the New Zealand dollar and Japanese yen for higher profit margins.
The Methodology of a Carry Trade
Because the goal of a carry trade is to pay a lower interest rate on the asset you’re borrowing, you should benefit from a higher interest rate on the asset you’ve purchased. The majority of traders will take a bullish position in the hopes of seeing the higher-yielding currency rise in value.
One of the common strategies, especially for Forex traders, is the use of leverage. Keep in mind that if the deal goes well, leverage can help you increase your profits. Still, it can also multiply your losses if the trade goes wrong. When trading on margin, traders should exercise caution and always have a risk management strategy in place to mitigate any capital losses.
Positive Trading Strategy
This method entails borrowing a low-interest currency and investing it in a high-interest currency. This method is frequently utilized on lucrative currency pairs, in which a trader borrows low-interest Japanese yen and buys New Zealand dollars (NZD) that come at a much higher interest rate. For this example, we will say that the Bank of Japan determined an interest rate of 1% while the Bank of New Zealand has it set at 6%.
Thus you are facing a 5 percent positive carry value on this currency pair. If the trader’s original position is worth 5,000 NZD, you will get 5% if the currency pair appreciates. It means that each time that happens, you will be earning a net of 250 NZD.
Not only that, but also you will make an initial net profit in a positive carry trade since you will be paid interest for holding the position. However, if the base currency’s interest rate, in this case, the NZD, decreases, and the quotation currency’s (JPY) interest rate rises, you will lose money.
Negative Trading Strategy
This approach entails borrowing a high-interest currency and purchasing a low-interest currency, with the expectation that the lower-interest currency will rise in value relative to the higher-interest currency.
Negative carry trading strategies often have a tighter interest rate spread than positive carry trading strategies due to the structure of the currency market, which frequently uses major currencies as the currencies with low interest (base), such as the US dollar or Swiss franc.
Let’s pretend you’ve seen that the interest rate on the USD is currently 0.5 percent and the interest rate on the GBP is currently 1.5 percent for the sake of this example. This indicates you’ll have a –1 percent negative carry. Consequently, you take a position on the GBP/USD currency pair, borrowing the higher-yielding US dollar while purchasing the lower-yielding British pound. You’d do this under the belief that the pound’s interest rate will grow above the dollar’s, resulting in a profit.
Advantages of Carry Trading
As long as the currencies stay steady, the carry trade works well. The high-yield currency will provide a consistent return to the trader. When the currency of the high-interest-rate nation appreciates, the transaction works even better.
Thus, an investor who redeems the bonds can use the stronger currency to pay off the debt in the low-interest currency. The difference is pocketed by the investor. It becoming a trend leads to a higher demand for high-interest-rate bonds – the second step is selling it off for a profit on a secondary market.
Risks of Carry Trading
When the opposite such as the depreciation of the pair happens, traders are in severe danger. It happens in a yen carry trade when the value of the yen rises, and the value of the dollar falls. Traders must get additional dollars to repay the yen they have borrowed. They may become bankrupt if the discrepancy is large enough.
Traders might also get into difficulty if currency prices fluctuate dramatically during the year. They must keep a minimum balance in their brokerage account. The broker may shut the account if the currency fluctuates a lot and the trader does not have enough extra cash to keep the minimum balance. If this happens, the trader may lose all of their money.
Now you know exactly how carry trades work. This means you can make the best financial decisions for your portfolio.