Imagine getting paid interest everyday for holding onto a trade. You don’t need to be actively trading or constantly looking at the market – all you need to do is HOLD! When I was learning to trade Foreign Exchange, I was fascinated by how carry trades work. So, I am going to spend this week’s blog post talking about carry trade. What is carry trade? How does it work? When does it not work? Can you profit from it? Let’s discuss.
Before we start talking about carry trade, it is important that you understand how interest rates affect investors’ decisions. Every country has its own version of the Federal Reserve, who monitors and dictates the interest rates for their respective countries. Given that the investment is safe, investors are constantly chasing higher interest rates. Why? Well, imagine if you are given 2 banks. One bank is paying you 3% interest on your money in the checking account, and the other bank is paying you 0.02%. Which one would you pick? 3% right? Similarly, investors utilize the interest rate differentials to generate a steady profit. What does that mean? That is exactly what carry trade is. Let me illustrate with a couple examples.
Imagine that the US Federal Reserve has decided the US interest rate to be 1.5%, and the Reserve Bank of New Zealand (RBNZ) has decided the NZ interest rate to be 2.5%. The way carry trade works is: you pay interest on the currency you sell, and you collect interest on the currency you buy. So, when you sell your USD, you are paying 1.5% interest. However, when you buy NZD, you collect 2.5% interest. This means that you are netting a profit of 1% every hour, every day until you hold onto the trade. Your profit is equal to the money collected from the interest rate difference. Currencies are always traded in pairs i.e. when you are buying one currency, you are selling the other currency that you have. This means that you can decide which currencies you want to buy or sell in order to maximize your interest rate difference.
Historically, individuals would sell Japanese Yen (JPY) or Swiss Franc (CHF), and would buy a developing country’s currency. JPY and CHF are known to have near zero interest rates, which means it is free to borrow (sell) those currencies. Developing countries (higher risk) pay high interest rates because they want to attract foreign investments. Countries like Argentina pays close to 20% interest. So, if you pair up Argentine Peso (20% interest) and JPY (0% interest) for your carry trade, you would be receiving an interest payment of about 20% every day until you hold onto the trade. (Note: Pairs that do not include USD are not very liquid.)
When does carry trade work? Carry trades work when investors are not risk averse. In other words, carry trades work best when investors want to take risk and feel optimistic enough to buy high yielding currencies (Argentine Peso from example above) and sell low yielding currencies (Japanese Yen from example above). When does carry trade not work? Carry Trades don’t work when the country’s economic prospects (Argentina and New Zealand from the examples above) look poor, and when investors are highly risk averse. When risk aversion is high, investors don’t take risky ventures. Investors would put their money in safe haven currencies like USD, CHF or JPY rather than buying risky high yielding currencies. Can you profit from carry trade? Yes, if you pick the correct currency pair (that gives you a positive interest rate differential), know that investors are willing to take risk, and the economic prospect of the country looks good, then you can definitely profit from carry trade.
Hope you learned a little and found this blog post helpful. We talked about how carry trade works, interest rate differential, currency pairs, when to enter, and when not to enter into a carry trade. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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