A carry trade is a forex strategy that aims to profit from interest-rate differentials between two currencies.
Traders using this strategy sell low-yielding currencies against higher-yielding ones, following the forex principle “buy low, sell high.”
It is among the most popular trading strategies in the foreign exchange market. It is often used when trading the AUD/JPY and NZD/JPY pairs.
Traders use a carry trade strategy to profit from the difference in interest rates in a currency pair.
A trader borrows a low-interest-rate currency and invests it in a high-interest-rate currency and earns from the differential in interest rates. This strategy is used with leverage to increase potential returns.
It follows the simple yet effective principle in forex - buy low, sell high. The first step in carry trading is to select a currency pair with contrasting yields.
The next step is to buy the currency with a low interest rate and then invest it in the high-yielding currency.
For example, the Japanese yen (JPY) is known for being widespread against other currencies such as the Australian dollar (AUD) and the New Zealand dollar (NZD).
Let’s try an example and see it in action!
Say you are a forex trader who wants to trade JPY/AUD because of the high interest rate differential!
As of writing, the JPY interest rate is 0.25%, while the AUD interest is 4.35%.
You would aim for the highest possible profit of 4.1%, which is the interest rate differential between the AUD and the JPY.
AUD interest rate (4.1%) - JPY interest rate (0.25%) = 4.1%
To execute a carry trade, you must borrow a funding currency, in this case, the JPY, and convert it into AUD. You can convert the investment profit back to JPY as the investment matures.
For instance, you borrow 1,000,000 JPY and convert this to the AUD. Let’s assume the exchange rate is 1 AUD = 90 JPY, so you get AUD 11,111.
Next, you invest the AUD 11,111 in an Australian bank or other instruments that offer a 4% annual interest rate.
Over a year, you earn 4% interest on your investment, which amounts to AUD 444.44.
Afterwards, you can now pay the 0.25% interest on the borrowed JPY 1,000,000, which is JPY 2500.
If you convert that back to AUD, you only have to pay AUD 27.78.
This means that your net profit is AUD 444.44 (earned) - AUD 27.78 (paid) = AUD 416.66 (profit), assuming the exchange rates did not change.
If the exchange rate moves against the yen, then you can profit even more. However, if the JPY becomes stronger, you will earn less than the intended 4.1%.
A common leverage offered by brokers is 10:1, which means a trader borrow and potentially earn 10 times their profit.
Based off our earlier example, if you trade with a leverage of 10:1, your profit becomes AUD 4166.6!
It’s not hard to see the appeal of carry trading; however, it also has equally disastrous outcomes.
Carry trading is most profitable when central banks are raising interest rates.
People trading currencies during this time will further push up the value of a currency pair.
On the other hand, carry trades also work well during times of low volatility. If the currency doesn’t move, the traders can collect their expected interest rate differential.
During stable market conditions, carry trading can provide consistent returns.
While carry trading is often seen as a profitable investment, it also has its risks and limitations.
The major risk of a carry trade is the uncertainty of exchange rates.
For example, let’s consider the JPY. The JPY has often been used in carry trades because of its low and stable interest rates.
However, in July 2024, the Bank of Japan raised its interest rates for the first time in nearly two decades.
This caused all trades involving borrowed yen to unwind, causing traders to reassess their carry trades.
Furthermore, because carry trades involve a lot of leverage, even the smallest movements in exchange rates can cause much larger losses than initial investments.
In the next lesson, we'll learn more about when carry trading is most profitable - and when it's not!
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