Carry trading are like some arbitrage techniques, but not identical, since if the market conditions change against the carry’s favor, then losses are inevitable to happen. The main and most significant risk carry trading has, is the uncertainty in the exchange rates. Usually, high levels of leverage are used for carry trades and even small movements in exchange rates may result in huge losses. Many traders use exotic currency pairs, like AUDJPY and NZDJPY for carry trading since the interest rate spreads of these currency pairs can be quite high.
Let’s summarize how carry trading works in forex market:
Borrowing: A trader can borrow money in a currency with a lower interest rate. This can usually be done by selling the low interest rate currency in the forex market. This is also known as the ‘funding currency’.
Investing: The trader then invests the borrowed funds in a currency or an asset with a higher interest rate. This higher yield currency is referred to as the ‘target currency’.
Interest Rate Differential: The trader earns the difference between the interest rates on the two (2) currencies. In the event the target currency has a higher interest rate than the funding currency, then the trader earns a positive carry. This has as a result generating an income stream from the interest rate differential.
Exchange Rate Movement: In addition to the interest rate differential, carry traders also seek opportunities to profit from exchange rate movements between the two currencies. In case the target currency appreciates relative to the funding currency, then the trader can also realize capital gains in addition to the carry income. By trading in the direction of a positive interest, traders can receive both trading and interest earnings, which can be magnified with the use of leverage.
As stated above though, there are several Risk factors to be considered too in case a trader decides to follow Carry Trading strategy.
Traders’ plan may go sideways due to:
Exchange Rate Risk: If the target currency depreciates against the funding currency, then the trader can incur losses that may overweigh the carry income.
Market Sentiment: Carry trader may be influenced by market sentiment. Sudden shifts on prices, economic conditions may turn the general market conditions against the trader and the strategy which is being used.
Leverage: High leverage can be used to amplify potential returns. With high leverage though, comes high risk. In the event there are large market movements significant losses may occur, even leading to total loss of initial investment.
Central Bank Policies: Central banks’ monetary policy decisions can impact interest rates and affect carry trading strategies significantly.
Let’s go through a simplified example for a carry trade in forex, using CurrencyA (Funding Currency with 2% annual interest rate) and CurrencyB (Target Currency with 5% annual interest rate).
As explained above, the first steps are to borrow (in CurrencyA) and invest (in CurrencyB). Hence, we can borrow $100,000 in CurrencyA at an annual interest rate of 2%. Then, we can convert the $100,000 into CurrencyB and invest it at an annual interest rate of 5%.
The interest rate differential between CurrencyB and CurrencyA is 5% - 2% = 3%.
Now, to calculate the Carry Income, we need to determine the interest we earn on our investment in CurrencyB and the interest rate we need to pay on the borrowed funds in CurrencyA.
CurrencyB: $100,000 * 5% = $5,000 (interest earned)
CurrencyA: $100,000 * 2% = $2,000 (interest to be paid)
Therefore, the total carry income for a year should be $5,000 - $2,000 = $3,000.
Keep in mind that the above example and explanation for carry income is a simplified one and does not consider other major financial factors (exchange rate movements, transactions costs, leverage, etc). Carry Trading involves various risks and market conditions complexities.
It is important to note that carry trading can be profitable during periods of stability and low volatility where there are no big movements in the market. Traders also need to understand the risks involved and assess the market conditions properly before implementing a trading strategy. As any investment strategy, Carry Trading should be implemented after thorough research and an understanding of market dynamics.