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 |
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.