As a trader or investor, you must understand the importance of interest rates in the financial markets. Central banks make interest rate decisions based on various factors, including the state of the economy, inflation, unemployment, trade exports, and more.
If a trade involves an analysis of one country's interest rate conditions relative to another as the main decision point in evaluating a potential trade, this type of trade is called a carry trade. In a carry trade, the medium to long term trader expects to profit from the interest rate difference paid between currency pairs.
In a carry trade, an investor can profit from both interest rate differences and favorable price movements. However, the direction of the currency pair is sometimes a minor issue, as most rollover positions are taken based on interest rate differentials.
In today's article, we'll take a look at how the carry trade works, break down its benefits and risks, and discuss a few trading strategies that can be used.
What is a carry trade?
So what is a carry trade? Long before we get into that, let's first take a look at what the term "carry" means when it refers to investing.
Carryover refers to the ownership of any asset. When you buy an asset, you are holding that asset. Thus, a transfer trade at its most basic level is a trade aimed at making a profit by exchanging one asset for another, each of which has its own unique value.
Let's start with a simple example. As an investor, you want to invest in a sound investment. Thus, you decide to place part of the funds you have allocated in a bank deposit. After doing some research, you will find that you can borrow money in your country (for example, in the USA), at 3.5% and invest it in an Australian bank with a yield of 6.50%.
Your funds are insured in both banks, so your investments and profits are guaranteed. So you decide to take out a loan from your US bank at a lower interest rate and deposit funds with an Australian bank for a higher rate of return. By doing this, you have just entered into a carry trade. This is called arbitrage trading.
Thus, when one asset is held for a while, it makes a profit for you. Holding one asset can also generate a loss. In our example, we have a positive result when we borrow in US dollars and invest in an Australian bank.
Using the currency markets, we can make a similar trade and this method is very popular with big banks and hedge funds. Currently, independent traders can also use this type of trading. Essentially, trading can be done in the foreign exchange markets by borrowing a currency with a low interest rate and using it to buy a higher yielding currency.
You will receive the difference in interest from your broker directly to your deposit as long as you have a positive rollover pair. On the other hand, your account will be charged with interest while you are trading with a negative carry price.
How does a carry trade work?
What is the mechanics of carry trading? To understand this a little better, we need to take a deeper look at what goes on behind the scenes of currency trading. Have you asked yourself when you buy USD/JPY or AUD/JPY or any other pair to that effect, what are you actually doing?
Let's take the USD/JPY currency pair as an example. When you open a USD/JPY trade, you are effectively buying the US dollar and selling the Japanese yen at a fixed contract size and at the current exchange rate. We all understand that when we buy USD/JPY, we want the price of USD to rise against JPY. But on a more structural level, you are essentially borrowing the Japanese yen to buy the US dollar.
Now let's turn our attention to how a trader can make money in a carry trade. Well, as we have already said, the carry trade is an arbitrage trading method in which we look for a higher percentage return on a currency pair in order to make a profit during the holding period of the asset.
If the price of a currency pair stays the same for the entire time, you will earn profit and interest. If the price of a pair moves in your favor when you are involved in a carry trade, you will earn interest along with the difference in the price of the currency pair.
But the carry trade also has its risks. Just because there is a difference in interest rates, there are other considerations to consider. If we enter into a positive carry trade and the price of the currency pair decreases, then we will lose money due to the depreciation of the exchange rate. The amount will depend on the actual price drop and the corresponding leverage we used in our trade.
A fall in price could outweigh any difference in interest rates many times over. Thus, even though we can get a good interest income by investing in a positive direction, we still have to take into account all possible risks.
Rollovers and swaps
In the foreign exchange market, settlement takes place two days after the transaction is registered. Brokers use in this case the transfer of positions (rollover). This means that positions are automatically rolled over to the next settlement date. Thus, the physical delivery of the currency is never made.
Most brokers generally use the 5:00 pm ET close of the New York session as their settlement time, but this may vary from broker to broker. Particular attention is paid to transactions between Wednesdays and Thursdays. Since settlement does not take place on weekends, these trades are settled on Monday with an additional two days of interest accrual.
A swap agreement, also called a swap , is a kind of currency agreement between counterparties. Typically, the dealing bank uses the Libor overnight rate plus a certain spread to calculate interest. Depending on the arrangement your broker has, they will then add their own fees to it to arrive at the final value of the swap.
How to calculate interest income
As we have said, one of the main advantages of a positive carry trade is the ability to earn passive interest income. This income is earned for each day we trade with a positive carry, or paid out by us for each day we trade with a negative carry. And since most traders use leverage in their trading, the carryover percentage can increase.
Let's do some math to understand how to calculate rollover interest.
Daily interest credit / debit = notional contract value * (base currency interest rate - currency quote interest rate) / 365 days a year * current base currency rate
So let's plug in some numbers into this equation using the example of a hypothetical currency trading for EUR/USD:
We are long (1 lot) EUR/USD and EUR/USD is trading at 1.2000. The short-term interest rate in euros is 4% and the short-term interest rate in US dollars is 2%.
100,000 * (0.04 - 0.02) = 2,000 / 365 x 1.20 = 438
2000/438 = $4.57
Thus, our daily premium credit for a long position would be $4.57. On the other hand, if you are short EURUSD, you will have to pay this amount every day.
However, keep in mind that the amount will vary slightly as banks use an overnight interest rate that will fluctuate daily. Based on this example, we want to calculate what our annual return will be, assuming that the interest rate paid remains the same:
If we take $4.57 and multiply by 365 we get $1668.
Assuming you are trading with 1:10 leverage, this position will net you 1668 for $10,000, resulting in a 16.68% return. Keep in mind that you are not paid interest on the notional value, but on the amount of $10,000. There are forex trading calculators that will make this calculation easier for you.
How to find suitable currency pairs for a carry trade?
When looking for potential candidates for currency trading, we must evaluate various factors so that our trade has the highest chance of success. The first thing we should do, even before we consider the differences in interest rate ratios, is to consider the financial stability of the countries for which we will use the carry trade.
You will find that the highest differentials can come from exotic pairs, but at the same time, the highest risk also comes from these pairs due to the financial uncertainty and less creditworthiness that some of these countries have.
Next, we must compare interest rate differences between the currency pairs that passed our test in stable economies. There are several resources on the Internet that you can go to to find the most profitable currency pairs.
You should also be able to get this data from your brokerage platform, however, it is advisable to find an independent source where you could get this data. Why? Because each broker will pay a different yield. By using an independent source for analysis, you will be able to find the brokers that pay the highest returns per currency trade.
Some of the more popular rollover pairs are AUD/USD, AUD/JPY, NZD/USD, and NZD/JPY. They represent currencies from stable economies with the highest interest rates.
It is also important to take into account the change in current interest rates for currency pairs. Do we expect interest rates on the currency we are buying to rise relative to another currency over the period we hold our position? Also, we should spend some time on technical analysis . Think about what the chart is telling us and decide if it makes technical sense to enter into a carry trade.
Suitable trading strategies
The first type of strategy a trader can use in a carry trade is the basic buy and hold strategy. Once you have done your research on the economic viability of countries, interest rate differentials, potential interest rate movements and broker returns, you can choose the currency pair that you think will fit your criteria.
Using a buy and hold strategy, you simply buy a selected positive carry pair and hold it for a fixed period of time. It can be 3 months, 6 months, 1 year or longer.
With any type of investment, diversification is usually the best defense against adverse events that could seriously damage your bottom line. Diversifying across a basket of positions generally provides a smoother capital curve and provides an optimal ratio of return to drawdown.
Thus, using this concept, we could buy a basket or a portfolio of positions to trade. As a result, any adverse price reactions will only have a nominal impact on our entire portfolio. Typically, this is how professional banks and hedge funds implement their carry trade strategies.
Technical traders can also benefit from the carry trade. Most technical traders tend to have shorter holding times.
When interest rate differentials widen in a pair, long-term traders come into the market to take advantage. As large participants enter into a transaction, this increases the demand for the currency, which leads to an increase in its price. Thus, a strong difference in interest rates leads to an increase in institutional demand, which also leads to an increase in prices.
A technical trader can use the trend following method to open his trades. Also, a swing trader can expect corrections to enter and add positions while prices are moving in their favor. Beware of using counter-trend strategies on pairs that are moving in a strong trend.
Conclusion
When carrying a trade, we must be selective and conduct a thorough analysis to ensure that we only select trade setups with the highest probability of making a profit. This entails studying the current economic conditions in the countries of interest to us, as well as applying additional methods of fundamental and technical analysis .
Rollovers should be used as a long-term approach to trading. We have seen that the carry trade offers a double benefit to the trader in terms of interest income opportunity and potential price growth. But keep in mind that the carry trade has its own risks, which should be minimized using sound position sizing and money management principles .