What is Carry trade?The word Carry means the returns we obtain for holding an asset. When we ‘Carry’ commodities for a long time, we end up with negative returns as they incur storage costs. But this is not the case in the Forex market. We do not actually Carry any physical entity.
Historically, before the Lehman crisis, the USD-JPY carry trade was the most prominent trade where borrowing used to come from the Japanese market because of Bank of Japan's accommodative monetary policy of low interest rate since the 1990s, while on the flipside, the US Federal Reserve maintained elevated interest rates. The interest rate differential spread between the US and Japan prompted many traders to sell yen at low rates and buy dollars to earn the higher rates.
Inevitably, there are two risk factors involved in the forex carry trades, namely the exchange rate risk and interest rate risk. The former impacts a lot when there is a massive move in the exchange rate and this may lead to substantial loss in the base capital. The latter defines the profit yield of the carry trades positions. The wider the interest rate differential, the wider the opportunities.
How do currency carry trades work?Currency carry trades work by enabling market participants to profit from interest rate differentials between the different currencies in a forex pair. Because forex is always traded in pairs, traders are simultaneously selling one currency while buying another. It is this technicality in forex transactions which makes currency carry trades possible.
When dealing forex, the currency on the left of the pair is known as the base currency, and the currency on the right of the pair is the quote. The price given for a forex pair is always the price of how much of the quote currency a trader would have to spend in order to buy one unit of the base currency.
The Carry Trading AdvantageTrading in the direction of carry interest is an advantage because there are also interest earnings in addition to your trading gains. Carry trading also allows you to use leverage to your advantage. When the broker pays you the daily interest on your carry trade, the interest paid is on the leveraged amount. For example, if you open a trade for one mini lot (10,000 USD), and you only have to use $250 of actual margin to open that trade, you will be paid daily interest on $10,000, not $250. It can add up to large yearly returns.
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Why It Is Risky
There is a fair amount of risk to the carry trading strategy. The currency pairs with the best conditions for using the carry trading method tend to be very volatile. For this reason, you must conduct carry trading with caution. Nervous markets can have a fast and heavy effect on currency pairs considered to be “carry pairs.” Without proper risk management, traders can be drained by a surprising and brutal turn.
Currency Carry Trade Example
As an example of a currency carry trade, assume that a trader notices that rates in Japan are 0.5 percent, while they are 4 percent in the United States. This means the trader expects to profit 3.5 percent, which is the difference between the two rates. The first step is to borrow yen and convert them into dollars. The second step is to invest those dollars into a security paying the U.S. rate. Assume the current exchange rate is 115 yen per dollar and the trader borrows 50 million yen. Once converted, the amount that he would have is:
U.S. dollars = 50 million yen ÷ 115 = $434,782.61
After a year invested at the 4 percent U.S. rate, the trader has:
Ending balance = $434,782.61 x 1.04 = $452,173.91
Now, the trader owes the 50 million yen principal plus 0.5 percent interest for a total of:
Amount owed = 50 million yen x 1.005 = 50.25 million yen
The phrase "carry trade unwind" is the stuff of a carry trader's nightmares. A carry trade unwind is a global capitulation out of a carry trade that causes the "funding currency" to strengthen aggressively. This happened with the Japanese yen during the financial crisis.
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