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.

Want to trade forex online? Important tips to bear in mind

Most of us want to trade forex online. It could be for many reasons. Some like to trade forex simply because love to play with the financial markets. Others see forex as a way of alternative investment. Whatever your reasons may be, here are some important tips to bear in mind even before you start trading or investing in forex.

Currency markets and the movers and shakers

Ask a seasoned forex trader on how they divide their time trading forex and the most obvious answer you get is the amount of time they use in order to analyze the markets and looking out for economic news and developments. These are two of the most important factors that tend to directly influence the economy of country and thus impact the currency’s value as well.

When you have a good understanding of the market movers and the news that you need to follow, it would be as obvious as looking into the various signs that forecast how the currency prices will move.

Because the value of a currency is directly tied to a country’s economy, factors such as political stability, economic strength and to some extent even the geographical factors such as weather tend to influence the prices. It is little wonder why, that so many experienced forex traders tend to spend more time into analyzing and reading the charts. This basically prepares them for upcoming trends or price falls and thus such traders manage to fare better than those who just trade blindly on gut feel.

Tools and tips for analyzing forex markets

There are many ways for traders to get started in analyzing the forex markets. One specific tool that is a ‘must have’ in every forex trader’s arsenal is the forex economic calendar. The economic calendar is nothing but a list of events scheduled for the day or the week or month, depending on how you wish to see it. Traders usually prefer the weekly charts, if they are weekend strategy planners or perhaps the daily chart which gives details on the day’s upcoming economic events.

Most of the events usually carry the currency that will be affected, time of the release and the release website. Other critical information also includes previous performance and the market expected data. Traders, especially forex scalpers find it very beneficial to use the economic calendar as it can help them to prepare their forex scalping strategy.

Risk management is another important factor that we will touch upon. A wise trader usually places their traders in a way that they limit their risks. This can include, using only a small part of their invested capital to using trailing stops and setting up the stop loss and take profit levels. All of these combined basically are targeted towards building a safety net for the trader in the event the markets do a reversal and the prices go against your trades.

It is always good to focus on a single currency pair instead of trading 3 or 4 pairs at a time. This helps you to retain your focus and also pick any signals you might see from the market events. Looking at charts for a currency pair and how it has been performing in the past few days is a good indicator on how things stand and can help the trader to gain context in this aspect.

The above tips are just tip of the iceberg and indeed volumes can be written about the many important tips for forex traders. However, the key is to start slow and steady and always look for long term gains instead of chasing the short term profits, which might seem big enough to give it a chase. In forex, people fail because either they are too greedy or do not follow a trading strategy, let alone having a goal.

This article is aimed towards beginners in forex who want to make the right start.

Weekend Forex Analysis - A strategy worth exploring

While the forex markets operate 24 hours a day, trading is at its minimal during the weekends are most of the major trading markets such as London, US, Asia are closed on the weekends. Some traders tend to make use of this slow periods in order to draft up a trading plan for the week ahead. When markets are closed, it provides a different environment, where in the trader doesn't have to do much expect to focus on the week's upcoming events and how the currencies will react in the week ahead.

In this article, we'll outline some ways on how you can conduct your weekend forex trading analysis and how it can help you out for the week ahead.

Forex Charts - Past Week's Analysis

Looking at forex charts during the past week can prove to be detrimental for traders in order to get an idea on how and where the markets are by the time the markets were closed on the weekends. Furthermore the price movements can offer a great source of information to get an idea on how the prices were moving during the previous week. Reflecting on past week's charts and also analyzing any of the trades made can provide some insights for traders and rectify any mistakes that might have been made. Various trading strategies such as forex hedging and scalping can be planned out in advance.

Forex Economic Calendar - Looking ahead

The Forex economic calender is a great way to plan the trading week ahead. Traders know that currencies tend to get very volatile during important news releases. By preparing a trading plan for the week ahead, based on the economic calendar can be a great way to build a trading strategy. Coorelating the week ahead based on previous weeks price movements can help traders to identify potential trading opportunities and prepare for any eventualities as well.

Focus on the fundamental

Forex fundamental analysis can be a great way to gain insights into the most important market movements and also the price action on the currencies in focus. Fundamental analysis can help give the trader insights into the market and thus enable traders to plan their trades accordingly. As traders know that there are many factors that influence the currency prices, fundamental analysis can help the traders to get a better economic and political idea on the countries in question which can tend to influence the currencies.

Forex weekend analysis is a great way for traders to relax and observe the forex markets without having to spend a great deal of time focusing on their trades. Weekend forex analysis should infact become one of the basic steps for traders in order to plan for the long term and also prepare for the trading week ahead.