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.

Is a Forex Managed Account Right for you?

In the ever changing investment landscape managed forex accounts continue to be at the forefront and at times are the preferred choice of investment. Irrespective of your investment strategy or style, smart investors follow one simple rule, which is to diversify. Putting all your eggs in one basket, or in context, investing all your money into the same kind of stock or mutual fund can prove to be dangerous. The advantage with diversifying your investment portfolio enables you to manage your risks better and at times can help you offset any losses you might incur in other investments.

When it comes to diversifying your investment portfolio, the first things that comes to mind is mutual funds, stocks and bonds. To the average investor these might seem different, but there are subtle underlying factors that are common to all three and it would be naive if you would think you have a good diversified portfolio by investing in just mutual funds, stocks and bonds.

Alternative investment options, such as forex managed accounts is one investment product that should be considered. The reason why many investors hesitate to go ahead with a managed forex account is the large prevailing myth that you can end up losing your money or perhaps the managed forex account you deal with cannot be trusted much. Fact is that when speaking about losses, the same risks holds true whether you invest in a stock or in the bond markets.

Agreed, that investing in a managed forex account takes a bit more time and research compared to mutual funds or other relative products. The reason is because the other investment products are so common that it has become a large playing field for just about any investment company. When you look at the forex managed accounts landscape on the other hand, its still in its infancy, which could substantiate why it takes a bit more than usual when it comes to researching into a good forex managed account.

Forex is perhaps the largest financial market ever with stagerring numbers if you look closer and it is also one of the most volatile and dynamic markets. Within forex there are lot of sub categories such as commodities trading, indices and/or CFD's.

If you are looking to invest in a managed forex account, here is a great article to learn about the basics of investing in managed accounts in forex.

To conclude this article, we leave with some basic tips if you are considering a forex managed account investment.

Research into the forex managed account company. Its ideal that the company is legally registered and also take time to read through the terms and conditions.

Find out how much the minimum investment is required. Some managed accounts offer a low entry point of $2000 and upwards. However, the returns you see on such investments is quite low. On the other hand, this would minimize your risks and also give you time to evaluate on how your fund manager is operating.

Never give your money directly to the fund manager. The most safest route is to sign up with the forex broker your fund manager works with and to fund your own account. You can then sign the Limited Power of Attorney to authorize your fund manager to trade on your behalf.