A carry trade is a trading strategy in which an investor borrows money or purchases a financial instrument at a low interest rate and then invests the borrowed money in an asset that provides higher interest rate.
For example if an investors borrows say $20,000 from a bank. And bank charges him an interest fee of 1% of $20,000 every year. He uses this $20,000 to purchase a bond which gives him a 5% interest rate every year. Thus, he makes a profit of 4% every year.
Carry trade is very common in the currency market. Let’s see how it works. In very simple terms, an investor sells a currency with a low interest rate and uses the money to purchase a different currency giving him higher interest rate. So the strategy is to make use of the difference between the interest rates. Due to high leverage in the Forex Market, the profit can be very high. So, when applying the carry trade strategy you should be very careful in choosing the currencies to trade upon. It would work well when the interest rate of the currency we are planning to buy is expected to go up while the interest rate of the currency we are selling is expected to go down. In other words currency pairs with higher interest rate spreads is what you should be interested in. Thus, you should be well aware of the future interest rate changes for the currencies you wish to trade.
Let’s take an example of a trader who does currency carry trade. Consider a trader who wishes to take a long position in AUD/GBP. This means he is going to buy AUD and sell GBP. Assume that when he buys AUD, he receives 4% interest rate and when he sells GBP he pays 0.1% interest. In this trade he makes a profit of 3.9% interest rate. Thus higher the interest rate spread, the more profitable it turns out to be.
As with any other trading strategy, there is risk factor associated with carry trade as well. How do you manage your risk? As with any other trade, you have to follow your risk management approach. In carry trade you can restrict your losses by placing a stop loss. For example you would like to limit your losses to $5000, you could set up a stop loss order in such a way that you close out your position as soon you incur a loss of $5000 or more. You would still have received the interest rate payments before you closed your position. Yes, we know it sounds interesting and exciting.
Here is a list of some of the risks associated with carry trades:
• Currency Risk
What if there is an adverse price movement in the currency pair you choose to do your carry trade. So currency risk is nothing but the risk due to unexpected changes to the value of underlying currencies. In carry trade, choose the currency pair in such a way that the currency for which you forecast a higher interest rate goes high when compared to the currency with the lower interest rate. All these over the chosen time frame. We know that your next question would be how you end up with such a currency pair. The answer is through technical and fundamental analysis as this is usually going to be for longer time frames.
• Leverage Risk
Since Forex offers high leverage when compared to other markets, traders need to be very careful. We already know that carry trade can be really profitable due to leverage in the Forex market. At the same place, a small price movement in the adverse direction can lead to huge losses as well. Thus high leverage can work in two ways, it can be either favourable to you or against you.
• Interest Rate Risk
By now you know that with higher interest rate spread the currency pair can bring you advantages in Carry Trade. What if interest rate differential goes down or low. Obviously you would receive a lower return than expected. This is what we meant by interest rate risk.
Carry trade is the strategy of taking advantage from the difference in interest rates between two currencies. When managed appropriately, carry trading can be a profitable long-term strategy to stick too. But keep in mind that a currency can either appreciate or depreciate in value. And hence there are risks associated with carry trades which Forex traders should be aware of. The key is never risk more than what you can afford to lose.