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What is the Carry Trade?


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Besides penny stock trading, another growing form of investing in the Forex market is the carry trade. In short, an investor sells a currency with a low interest rate and uses the funds to purchase a second currency that carries a higher interest rate. By using this strategy and leveraging the trade, an investor can make a substantial return. The most often quoted carry trade strategy is the yen carry trade, in which Japanese Yen is the borrowed (or shorted) currency.

Historical background of the Yen Carry Trade

japanes yen carry tradeUnique conditions with the Japanese Yen became the impetus for a carry trade during the 1990’s. To understand why this became so, one needs to know some of the economic history of Japan. After WWII, Japan’s government implemented many tariffs and encouraged their people to save money and invest in domestic products. This policy lead to more money in Japan’s banks and it made loans and credit easier to obtain. Eventually this chain reaction effect caused Japan to run high trade surpluses and the cost of Japanese-produced goods were much lower than their competition overseas. Eventually this buildup of cash coupled with a deregulated financial industry caused asset prices to rise to exorbitant amounts. In 1989 the market peaked and a long decline followed called The Lost Decade in which the country experienced economic stagnation and deflationary pressures.

 

A Worldwide Carry Trade Emerges

the carry trade

During The Lost Decade in the 1990’s, the Bank of Japan decided to try new kinds of monetary policy in order to combat the kept interest rates as close to zero in order to encourage inflation and dissuade spending. By contrast the US had interest rates of around 5%. This allowed investors to borrow Japanese yen to buy US dollars. The interest rate differential was called a “carry”. Many large investment companies like Goldman Sachs were using this carry during the 90’s to help drive massive profits. This has continued into the 2000’s but has begun to shift as the world economy has changed.

Decline of the Traditional Yen Carry

One of the primary issues with the yen carry trade was that it depended on having a second currency with a high interest rate. In the 90’s the US dollar was around 5% but due to the world financial crisis in 2008 and the mortgage bubble in the US, the Federal Reserve began to adopt similar monetary policy to the Bank of Japan including holding interest rates near 0%. This has caused investors to look at other currencies such as the Australian Dollar, which currently holds an interest rate of 2.75%. Many utilizing carry trade strategy now utilize the low rate of the US dollar and the fact that it has been depreciating against most world currencies.

currency exchange dollar to yen

This is especially favorable to those borrowing USD as the amount needed to repay the loan is smaller and contrasts with the Japanese Yen which up until recently had been appreciating against almost every world currency.

Understanding the Risk Factor of the Carry Trade

As with all Forex trading, the primary risk/reward is defined on which direction the exchange rate moves and where your position is open. An issue in finding a good currency pair to utilize the carry is that the exchange rate moving is the risk. The currency exchange rate needs to be fairly stable and predictable in order not to risk losing far more than a carry differential will produce. Considering most traders will be utilizing leverage to maximize profits, this can also maximize losses if a pair moves against you.

Re-Emergence of a New Yen Carry?

While the global financial crisis signaled the end of an era in lucrative yen carry trading, there might be a new potential on the horizon. The Bank of Japan has again shifted monetary policy in order to end what it calls “endaka”, or “strong yen”. For Japan, it is detrimental to have a highly valuable Yen as their economy is strongly based on exports. A strong Yen causes the price of goods sold overseas to rise. Coincidentally it also harms the yen carry trade. In April 2013, the Bank of Japan decided to spend $1.4 trillion USD over 2 years to double its monetary base and combat endaka.

Is Utilizing the Carry Trade For You?

This brings us to the final point. Does it make sense for you to use the carry trade? It’s unlikely that we will see the high interest rate differentials of the 90’s with modern monetary policy. It’s also unwise to eschew traditional Forex trading basics. Coupling knowledge of how to use a carry will help to maximize your potential gains and act as icing on the cake when Forex trading.

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The Currency Carry Trade Explained


Getting Started With The Currency Carry Trade

Currency Carry TradeThe currency carry trade is a way of trading currencies for profits by taking advantage of vastly different central bank imposed interest rates in different countries around the world. Traders and investors like the currency carry trade because it provides an opportunity to make significant trading profits via interest payments. The currency carry trade is especially appealing in the current low interest rate environment, because it offers significant potential gains from interest rate investments despite the current low interest rate environment.

Before a trader or investor initiates a currency carry trade, they must first open a FOREX currency trading account, which is known as a FX account. It is important to research the FX accounts offered by various FX trading firms, because the terms they offer for initiating, maintaining, and paying interest on a currency carry trade can vary amongst FX trading firms.

How The Currency Carry Trade Works

A currency carry trade involves buying or going long a currency that pays a high interest rate and selling or going short a currency that has a low interest rate.  This is done by purchasing a currency pair.  If the currency pair position is held overnight, the holder of the position is paid the close of trading the difference between the two central bank imposed interest rates for the opposing currencies.

Here is an example of the currency carry trade.  The United States Federal Reserve has set interest rates in the U.S. at close to 0.25% in 2012.  Other countries in the developed world have much higher central bank imposed interest rates due to the fact that they have strong economic growth, such as Australia, where the Reserve Bank of Australia has set interest rates at 3.5% during 2012.  If a currency trader initiated a currency carry trade to make money from this interest rate spread, they would buy the Australian Dollar / United States Dollar currency pair, which would make them long the Australian Dollar and short the United States Dollar.  Each night, upon the close of currency trading, the firm managing their FX account would pay the trader nearly 3.5% for holding the Australian Dollar and would deduct nearly 0.25% for borrowing the United States Dollar.  The currency trader does not earn the total interest rate difference between the two currencies because the FX trading firm makes money by charging fees and charging a spread between the actual interest rates available and what they are willing to pay or deduct regarding interest, which is why it is important to research which FX trading firm to trade with before undertaking the currency carry trade.

While the currency carry trade can be highly profitable, if the spread between currencies remains wide for a long time, it also involves some trading risk, including risk of total loss of investment capital.  The primary risk associated with the currency carry trade is that the currency that one is holding long loses value versus the currency they are holding short, and the principal investment loses its entire value.  Some traders mitigate this risk by initiating a currency carry trade using margin, so that they maximize their earnings from the interest differences between two currencies but limit their downside risk to the amount of money they put up as margin collateral.

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Taking Advantage of the Currency Carry Trade


What Is the Currency Carry Trade?

currency carry trade

The currency carry trade is a trading strategy used by some investors. Investors who use this strategy buy foreign currency at a low interest rate. They then use the money to fund other investments that have larger payoffs. The key to successfully investing in the carry trade is to invest in currencies that have either a low interest rate or that charge no interest at all. In the past, countries have been known to lower their interest rates specifically to attract potential investors. The Japanese Yen, for example, was interest-free for years in order to promote its use in the currency carry trade.

How to Cash In on the Currency Carry Trade

The principle behind the currency carry trade is simple: buy a low-interest currency and use the money to fund a high-return investment. If you buy currency from a country with no interest rate, for example, you can then use that currency to buy high-yielding American stocks or bonds. Assuming that the American dollar stays strong, you will earn a large return when you sell your stock back for American currency. The risk to this strategy, of course, is that the American dollar can either drop in value or the low-interest currency can rise in value. Either of these situations could result in the loss of money.

If you are interested in investing in the carry trade, there are a few things you can do to minimize the risks. It is imperative that you have an understanding of international currency trends. In order to make good investment decisions, you must know not only which currencies are low-interest, but which currencies are not expected to rise in value. If you know what you are doing, however, the currency carry trade can turn out to be very rewarding indeed.

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