Carry Trade Explained

Financial jargon is notoriously difficult to decipher and understand. If you happen to know why any economist or financial analyst that can explain the jargon to you, chances are in that most cases their explanation is just not as simple as it seems. At least for the lay man who barely can manage to understand the difference between a stock and a mutual fund, or debt and equity as an example.

Thus, if you are like one of the layman who can often get it confused with words such structural fiscal reforms, collateral debt obligations, credit default swaps and many more, then it is time to get rid of this financial jargon and get down to the basics.

Let’s start with carry trade!

What is carry trade? Well, simply put, carry trade simply is borrowing one currency that has low interest rate and exchange it for another currency that has a higher interest rate and then lending it out. 

Thus, the arbitrage here, which is the difference in interest rates helps investors to exploit the loophole and make money as a result.

How does carry trade work?

For carry trade to work, investors need to have two currencies whose interest rate differences are big enough to exploit the arbitrage opportunity.

Because carry trade involves borrowing money at a cheaper rate and then investing is elsewhere to earn higher returns, carry trade can be done with either interest rates or even with various investment products.

For example, if you wanted to fund your U.S. equity positions, you could potentially borrow money from the Bank of Japan (figuratively speaking) which offers a negative interest rate. For the sake of simplicity, let’s assume the interest rate to be zero. Thus you don’t pay interest on your loan.

Now, you sell the yen in the interbank markets and buy U.S. dollars, with which you can now invest in the U.S. equities. Assuming that during one year, the U.S. equity markets gave a return of 10%, then you can simply withdraw your funds, convert part of it back to yen and pay back the loan.

This method, which is nothing but carry trade in practice just gave you 10% profit on practically no investment from your end (of course you have to put up some collateral to get the loan in the first place, which is a different story).

Even when you account for exchange rates, and even if the BoJ had a 1% interest rate, you would still have at the very least made a 5% profit off this carry trade strategy.

Does carry trade work all the time?

One of the things about arbitrage opportunities is that they tend to move in cycles. Whenever there is a loophole plotted, you can expect this loophole to be plugged sooner than later. That is the nature of the investors and the markets at large.

Still, there are many ways one can employ an arbitrate opportunity.

For example, if your domestic currency offers lower interest rates, you could look at converting your currency into a foreign currency and deposit it in a bank to earn a higher interest rate. This method will be profitable only if at a future point in time the currency rate will not depreciate further.

As you can see there are significant risks involved with carry trade strategy and that is something that investors should bear in mind.

What is carry trade in the context of forex?

When it comes to forex, carry trade is referred to the overnight swaps that are charged on the positions. For example, assuming that the U.S. interest rates are at 2%, and the Bank of Japan has a -0.10% interest rate, then when you buy and hold USDJPY you can expect to make a 2.10% interest on your position.

This positive interest rate is known as a positive swap and it is applied to your equity.

On the contrary if you held a USDJPY short position, then you would be making a -2.10% negative interest or swap on your position which is debited from your equity.

Buying a higher yielding interest rate bearing currency and selling a lower yielding interest rate bearing currency is what is referred to as the carry trade concept in forex trading.

Example of carry trade in forex

The U.S. dollar, Mexican peso is a great example. Since 2016, USDMXN has been steadily rising during the presidential campaign on the hard-line rhetoric from Trump.

The U.S. dollar gained strongly despite the Mexican peso having a higher interest rate.

Carry trade example – USDMXN

The above chart you can see that despite the Banxico (Mexican Central Bank) hiking interest rates, USDMXN continued to steadily rise, when based on the carry trade policy, USDMXN should have been steadily declining. If a trader was engaged in carry trade here, it would have been a very expensive affair.

Should you consider carry trading as a strategy?

The above examples outlined in this article are just some basic examples and doesn’t account for other fees and factors that could eat into the concept of carry trade. Therefore, investors need to have access to large funds to make the 3% - 5% profits count for something.

For a retail forex trading, a carry trading opportunity is only as beneficial for the time period where they are holding on to a position. You can read more about what is carry trade in forex here.

An important concept to bear in mind is that just because a currency has a higher interest rate doesn’t mean that it will appreciate against lower yielding interest bearing currency.

Benefits of NDD Forex Broker Trading

In the evolution of forex brokers, ECN or NDD type of execution has been the preferred way for traders. It is therefore true that ECN or no conflict trading has been the way forward when it comes to trading forex online.

At the heart of the issue, lies the fact that an ECN broker represents a network of liquidity providers such as banks and hedge fund institutions alongside individual and institutional traders as well. With an ECN broker, the middle man is cut off as trading takes place within the ECN network. An ECN network should not be confused with a multilateral trading facility.

ECN forex brokers have made it possible for traders to trade in the live and dynamic trading environment which offers transparency of pricing and an improved execution of trades. Something which lacks when it comes to the traditional forex brokers operating in a fixed spread or a made up market environment.

An ECN operates on the basis of matching or pair the orders placed by the client. In other words, all the orders are collected into a central place and based on the orders  such as market or instant execution, the correct buy and sell participants are matched.

Trading with an ECN broker gives the benefit of trading in a transparent and a no conflict trading environment. No Dealing Desk brokers particularly make their money by charging a commissions on the trades, which is how they operate, thus eliminating the need for taking up counter positions or even having the need for a central trading desk.

Pricing and spreads with a NDD forex broker greatly varies in comparison to a fixed spread broker. Furthermore, the two aspects, namely pricing and spreads can be influenced by the participants themselves, for example if someone were to place a large buy order and vice versa.

When trading in an NDD environment, the advantage you get as a trader is the fact that your trades are anonymous. Meaning that no one really knows your information or your trade strategies. This is in stark contrast to when trading with a fixed spread broker, who in all probability knows who you are, has access to your past trade history, your total profit and loss and other such information which can be used to trade better against you.

As ECN trading starts to get more and more popular, many liquidity providers are coming on board to provide better spreads and pricing. Liquidity providers are made up of banks and also companies such as Integral or Currenex that bring with them their own liquidity providers on their ECN networks. Professional traders usually find it better to trade in a no dealing desk environment compared to trading with a fixed spread broker. Of the many advantages, ECN trading allows you the freedom to scalp or hedge your positions, especially of value is news based trading where price movements can be very volatile and to the right trader gives a great opportunity to make profits within a short span of time.

To summarize the above, it can be safe to say that the benefits of trading with a no dealing desk forex broker brings with it a great level of freedom, transparency and anonimity, which clearly lacks when it comes to trading with a market maker forex broker. For the more professional broker as well as for those who wish to take their trading skills to the next level, ECN trading is the right way to get started.