Carry Trade Forex Strategy

Carry Trade Forex Strategy

Submitted by adil on Tue, 11/26/2013 - 11:01

The world with its many currencies, economies, commodities and other subjectivities creates innumerable opportunities for people to benefit from. Particularly in financial markets, the numerous variables at play are often waiting for rightful exploitation from shrewd traders. For example, in an arbitrage the trader benefits by buying an underpriced asset in one economy, and selling it in an economy where it is overpriced.

However, arbitrage wipes out these within seconds if not minutes. The automated systems at hand with tens of thousands of traders automatically exploit and adjust arbitrage, leaving no opportunity for the market to make gains. There is still another option, which traders can use to make solid gains. It's called a carry trade. A carry trade is also a result of differing variables at play among different economies of the world, made easy to benefit from with faster operations and better technology.

In a carry trade, a trader exploits the interest rate differential between two different currencies. He does this by borrowing in a currency with low interest rates, converting it in to the second currency and investing that second currency on a higher fixed interest rate. For example, assume that the interest rates in the economy of currency X (CU-X) are very low, say 1%, and interest rates in the economy of currency Y (CU-Y) are high, say 5%, and the exchange rate is 1 CU-X= 2 CU-Y.

The trader then borrows, say 100,000 CU-X at 1%, and exchanges it in currency Y at the stated exchange rate and gets 200,000 CU-Y. The trader then invests 200,000 CU-Y at 5%. Hence, the trader gets 10 CU-Y per year of interest in CU-Y. If we assume a constant exchange rate, the trader converts this 10,000 CU-Y return at the given exchange rate back to CU-X, and gets 5000 CU-X. The trader has to pay interest cost for borrowing in CU-X, which is 1% of 100,000 CU-X, that is, 1000 CU-X. Therefore, on a whole, the trader makes a 4,000 CU-X profit.

The assumption of a constant exchange rate is the weakest link in this strategy. That is because a lot of forces interact to play out the spot rates. Therefore, if CU-X appreciates against CU-Y, the trader will lose money while converting/ translating the fixed investment return in CU-X. However, the likelihood is that that the CU-Y will appreciate against CU-X, because of the herd effect. That is the demand for CU-Y increases and the demand for CU-X decreases, as many traders scramble to take advantage of this opportunity. Hence, if CU-Y appreciates against CU-X, the trader gets a higher return when he converts/translates the currency from CU-Y to CU-X.

In the previous decades, when Japan was facing immense deflationary pressures, it was forced to cut its interest rates drastically. At that time, many traders borrowed in Japanese Yen, translated them in other currencies such as US Dollars and invested in higher interest yielding US Dollar investments. Therefore, in a carry trade, you get interest rate gain as well as possible exchange rate gains.