Interest rates are one of the biggest drivers behind currency movements. And one of the main reasons for this is the carry trade. Put simply, carry trading is a strategy for profiting from the difference in interest rates between two currencies. That means “cheap money” is borrowed, converted and lent out at a higher rate of return.
How Currency “Carry Trading” Works
To properly understand the carry trade, we first need to look at what’s actually going on when a trade is executed in the spot forex market.
When you enter into a trade, you in effect buy one currency and sell another for a given contract size, at the current exchange rate.
However, as most forex trading is speculative and done with borrowed money, it’s more appropriate to think of one currency being borrowed, and the other lent.
Just like when you go to a high street bank, when you borrow or lend money, interest payments are due. It’s no different in forex.
The basic aim of the carry trade is to borrow a currency with a low interest, and lend a currency with a higher interest. This results in a positive interest rate flow. Any due interest is paid to the trader – for as long as the position remains open.
This strategy can be very rewarding because interest is paid on the full amount of the contract. Since most forex traders use leverage, the carry trade can offer a substantial income yield. Though, this isn’t without risks (see below).
How To Choose A Currency Pair
In the last decade or so, the low interest currencies favored by carry traders have been the Swiss Franc (CHF) and Japanese Yen (JPY). Popular higher yielding currencies are the Australian Dollar (AUD) and New Zealand Dollar (NZD).
The base interest rate of the Australian Dollar is currently 2.5%. While the base rate of Japanese Yen is 0.1%. This means there’s a gross interest rate difference of 2.4%.
Let’s look at the cash flows in two opposing trades in AUD/JPY after one full day.
|Buy AUD/JPY||AUD||JPY||Sell AUD/JPY||AUD||JPY|
|Contract size||$100,000||-¥9,250,000||Contract size||-$100,000||¥9,250,000|
|Gross interest||$6.85||-¥25.34||Gross interest||-$6.85||¥25.34|
|Net interest||$6.04||-¥100.10||Net interest||-$7.66||-¥49.42|
|Net interest (AUD)||$6.04||-$1.08||Net interest (AUD)||-$7.66||-$0.53|
|Net interest (pips)||0.559||-0.100||Net interest (pips)||-0.708||-0.049|
Table 1: Cash flows in long/short carry trade example.
When we buy AUD/JPY, what we are doing in effect is borrowing Yen, and lending Australian dollars. With one standard lot, and the current exchange rate, this means we borrow ¥9,250,000 at an interest rate of 0.1% and lend the exact equivalent which is AUD$100,000 at a rate of 2.5%.
After holding the position overnight, we are “owed” $6.04 from the lent Australian Dollars.And we owe $1.08 from the borrowed Japanese Yen. This is once the interest rate spread (the fee) has been included.
So the long side would give us a net daily cash flow of $4.96.
When we sell AUD/JPY the reverse happens. We must pay interest on the AUD, and we receive interest on the Yen deposit. But, the small credit interest on the Yen deposit becomes negative once the spread is included.
This means we must pay $8.19 per day to hold the short AUD/JPY position.
It’s important to note, these amounts are fixed overnight. The rate on any day will will depend on the prevailing interest rates and fees charged both by the broker and the dealing bank (see below).
AUD/JPY “Buy-and-Hold” Example
Table 2 below shows the profit/loss statement for a long-term buy and hold carry trade. The amounts shown are for a long AUD/JPY position of size one standard lot. The table shows what would happen if this trade were opened at the beginning of 2004, and held for ten years.
|Year||Net Interest||Income||Exchange P/L||Total P/L|
Table 2: Long term returns in a 10-year carry trade.
The trade results in a net income of $38,013 in interest payments. The exchange rate gain over this period is $12,941. In this case, the payment stream from the carry interest more than compensates for the drawdown of the trade. The biggest being after the 2008 Lehman Brothers collapse – see Figure 1.
Even with a conservative 10x leverage, which would easily cover the position, this gives a total return of 509% and an annualized return of nearly 19.8% over a ten year period.
Not a bad return at all when compared to other investments over the same time period.
Carry Trade Strategies
There are two basic carry trade strategies:
- Buy and hold – where one or more positions are held for the long term.
- A trend following system – short term trades are entered/exited in the carry direction.
If you’re planning on using a carry trade strategy, the first step is to find the most profitable combination of broker vs. currency pair.
Charges vary enormously among brokers, and across different currencies. So it’s essential to check that your planned trade actually offers the best risk adjusted return.
Don’t assume that carry trading will be profitable in every case. It might look that way at first glance. But with many brokers, the interest spreads are so wide that they make most carry trades unviable.
The table below shows the top carry trade opportunities at the time of writing.
|Broker||Pair||Direction||Net Yield %||1 Year Interest/Lot|
Table 3: Most profitable carry trade opportunities.
The highest yielding pair is AUDCHF. This is currently giving a healthy 3.09% net yield. This is after a 0.25% spread applied by the broker.
The Swiss National Bank is aggressively intervening in the markets to weaken the Swiss Franc – the peg to the Euro has been in place for over two years now.
This has resulted in a negative overnight Libor rate which is why the rate differentials are so high with the CHF pairs. A risk to carry traders is that lifting of this policy could result in rapid appreciation of the CHF.
When setting up a carry trade, interest yield isn’t the only aspect to consider. If you’re planning on using a buy and hold system, it’s sensible to look at a long-term view on the pair too.
Some “exotics” may offer very high carry rates. Yet these currencies are often highly volatile and depreciate over time due to inflation and other factors.
The interest payments can provide a steady income stream in a carry trading setup. But the trader still has an exchange rate risk. That is, the risk that the currency exchange rate will change and cause a substantial loss on the trade.
Of course, the rate can go the other way and that would increase the profit to the trader.
What Influences Carry Currencies?
Real interest rates (adjusted for inflation) are one of the main drivers behind currency movements.
For this reason, currency pairs with carry opportunities often trend strongly in the direction of the interest rate differential. Trending can take place over very long periods of time when the economic backdrop is good and the interest rate expectations are upwards.
The main risk however is that higher yielding currencies are prone to steep and sudden sell-offs when the economic outlook changes or at times of extreme risk aversion.
These sell-offs are known as carry trade liquidation. When you have severe and sudden risk-avoidance, they can quickly turn into full-blown routs. Panic trading sets in and traders all look to unwind their positions at the same time.
Also, keep in mind that movement in carry trade currencies tends to be driven by the same fundamental reasons. What this means is that brutal crashes often impact all carry currencies in lock-step. Because of this, diversification across several pairs doesn’t help in most instances.
Figure 2 shows the massive liquidation of carry trades shortly before the Lehman Brothers collapse. This is followed by successive interest rate cuts due to the economic recession.
Understanding the “Cost of Carry Trading”
Just like when you lend or borrow from a high street bank, there’s a fee to pay. This is called the interest rate margin or spread. The dealing bank(s) plus the broker all add their fees into the mix.
This is why it’s important to understand the costs of carry trading and check what you’re actually being charged.
Most brokers do publicize their interest rate spreads on their websites. These are usually listed under rollover/swap charges.
It’s always good practice though to calculate the spread yourself to make sure there aren’t any “hidden extras”. This way, you’ll know the exact yield you’ll achieve with the trade. This is what you should always do before committing to any big carry trade positions.