Many trading strategies or systems that we are familiar with are based or grounded in technical analysis or indicators. Unlike these strategies, Carry Trade is a fundamental-based strategy.
Don’t mess with me, Rubén. The Carry trade, also sometimes known as the financial bicycle, is a strategy that allows you to take advantage of the existing differential in the interest rates of two different currencies.
Although it is a fairly short and simple definition, we must be very clear about a very important concept of fundamental analysis in Forex such as interest rates.
As you know, each currency represents the economy of a country as a whole. Well, interest rates are one of the most important fundamental indicators to analyze the state of a country’s economy and therefore, the strength or weakness of its currency.
In general, interest rates fix the cost of money, that is, the price we pay for using an amount of money for a certain time. It is very important that you know that one of the most important economic news that is usually published and affects the price of the currency in question is interest rates.
You should not confuse the carry trade with financial arbitrage. Arbitrage is a strategy that consists of obtaining an economic benefit by taking advantage of the price difference of a financial asset in different markets. And unlike the carry trade, in arbitrage the risk is very low.
- 1 1. Fundamentals of Carry Trade.
- 2 2. Objective of the Carry Trade strategy.
- 3 3. Some disadvantages of the Carry Trade.
- 4 4. A practical example of Carry Trade.
- 5 5. Risks associated with Carry Trade.
- 6 6. How to use the Carry Trade in the Forex market to maximize our profits.
- 7 7. Conclusion.
1. Fundamentals of Carry Trade.
As we mentioned earlier the differential in interest rates between two currencies offers traders and investors the opportunity to win in the long term.
The main idea of the carry trade strategy is very simple: the investor finances or borrows a currency with a low interest rate (weak economy), sells this currency and buys another with a higher interest rate (strong economy) .
Now, how can we know if an economy is strong or weak? There are several factors that affect interest rates, but inflation or the inflation outlook is one of the most important.
A strong or solid economy has good GDP growth (Gross Domestic Product) and good employment data, if people consume more goods and services, there is greater demand and inflation increases. To control the increase in inflation and keep it within the target range, the Central Bank of that country has to raise interest rates to limit inflation. By increasing the interest rate, the country becomes more attractive to attract foreign investment and this results in a revaluation or strengthening of the country’s currency.
On the contrary, if an economy is weak or growing very little, it has poor GDP and employment data, the consumption of products or services is low and that country cannot afford to have such a strong currency. The central bank must reduce or keep interest rates very low, in this way it encourages credit since it is cheaper for companies to borrow. Consequently, investors will want to take their money to another country with better interest rates by causing the local currency to devalue or become weaker.
Be careful with this because now the countries with the current situation have begun to lower rates and print money for free and even the US, which can be considered a strong economy, has very low interest rates. Same situation in Europe with the policies of the European Central Bank.
2. Objective of the Carry Trade strategy.
The carry trade has a clear objective: to obtain benefits from the interest rate differential and not from the price variation that can occur during the execution of this strategy. Therefore, benefits can be obtained from this strategy, even if the price of the currencies or currencies involved does not change a single pip.
However, as traders we hope that the currency in which we invest will strengthen so that by exchanging it for the currency that we borrow (we finance ourselves) the profit obtained is greater.
3. Some disadvantages of the Carry Trade.
One of the disadvantages of this strategy, as you may have already thought, is the risk that the currency in which it is purchased will devalue . This is largely due to the fact that the most common carry trade practice is to finance or borrow in developed countries with strong economies to invest in debt securities (fixed income market) of emerging countries that offer higher returns.
Another disadvantage of this strategy lies in the uncertainty that exists about the maintenance of current interest rates in the future. As it is a long-term strategy, interest rates tend to vary throughout the year (in fact we are seeing it recently) and although these variations are small, the final benefit will depend on these small variations that the central bank of each country can make .
4. A practical example of Carry Trade.
One of the main currencies that traders used to enhance the carry trade is the Japanese yen due to its very low interest rates (close to zero or even negative). This has changed because currencies with the euro or the dollar already have very low interest rates as well.
Previously, they borrowed the Japanese yen and then bought or invest in assets denominated in dollars, euros or other currencies of emerging economies.
Now let’s imagine that we want to carry out a carry trade and take advantage of the differential between the interest rates of the Japanese economy (with interest rates of 0%) and the economy of an emerging country like Brazil (with interest rates of 7%). The process would be more or less as described below:
- We borrow 10,000,000 yen at an interest rate of 0%, which means that within a year we would have to pay back 10,000,000 yen.
- We sell the 10,000,000 yen and buy dollars at an exchange rate of 100 yen per dollar and in this way we get 100,000 dollars.
- We sell the dollars obtained and buy Brazilian reais at an exchange rate of 3 reais per dollar, obtaining 300,000 Brazilian reais.
- With the Brazilian reais we buy bonds or bills from the Brazilian central bank with an annual maturity and with an annual yield of 7% . Within a year we will receive 321,000 reais (principal plus interest).
- Now we must repay the initial credit by returning the 10,000,000 Japanese yen that we borrowed . Assuming that the exchange rates have not changed, we exchange reais into dollars and get $ 107,000. Then we change the dollars to yen and we get 10,700,000 yen.
- Finally, we return the 10,000,000 yen of the initial credit and have 700,000 yen (equivalent to $ 7,000) of profit left.
In this way we have obtained a benefit based exclusively on the differential of interest rates. In this example we assume that exchange rates remain constant, but what would happen if, for example: the Japanese yen appreciates and after one year goes from 100 yen per dollar to 90 yen per dollar?
In this case, when exchanging the 107,000 dollars obtained to yen we will receive 9,630,000 yen. We must pay the initial loan of 10,000,000 yen, therefore, we would have a loss of 370,000 Japanese yen that would be equivalent to a loss of 3.7% in the carry trade operation.
5. Risks associated with Carry Trade.
As we could see in the previous example, one of the most important risks for the currency trader or investor arises when exchange rates do not move in his favor , that is, the currency he borrowed is revalued or the currency is devalued in the you invested the money you borrowed.
There is another risk, which is associated with the choice of the asset to invest since we can invest in the fixed income market, the variable market or the real estate market. In the case of stocks or the real estate market we do not have a guaranteed return and in the case of the fixed income market there is always the risk of default by the issuer of the bonds.
6. How to use the Carry Trade in the Forex market to maximize our profits.
In the Forex market when we open a position, we are basically borrowing a currency, exchanging it for another, and depositing it. All of this happens on a daily basis, so if a trade remains open from 5pm New York time, the trader will be paying the overnight interest rate in the borrowed currency and at the same time earning the interest rate. of the currency held.
Because each currency pair is made up of two currencies representing two economies with two different interest rates, most of the time there will be a differential in the interest rates of the pair. This difference will result in a net profit or interest payment.
Interest is paid in the currency being borrowed (sold) and credited in the currency being purchased. In this way, each currency pair has an interest payment and an interest charge associated with maintaining the position.
This means that if we buy a currency with an interest rate higher than that of the borrowed currency (sale), and we keep it open after 5pm New York time (11pm Spain), the net difference in interest rates interest will be positive and we will earn money from this.
In the opposite case, if the currency we buy has a lower interest rate than that of the borrowed currency, the net spread will be negative and we will pay interest to keep that operation open after 5pm (New York time).
This interest rate differential that we earn or must pay can be found on your trading platform under the name of Swap or Rollover . In the specifications of each currency pair we will have a swap for long positions (buy) and a swap for short positions (sell).
To use this strategy in practice we must take into account the following:
6.1. Find positive swap currency pairs.
You can see this information on your broker’s website or platform. If you use Metatrader you have it easy, you can see it by right-clicking on the asset in question in “contract specification”:
In this case you can see in the case of opening a purchase in the USD / TRY pair we would pay swap every day at the end of the session and otherwise if we open a short they pay us.
6.2. Perform a favorable swap transaction
Once we have located an opportunity (this is easy) you should not do an operation just because. The idea is to make an operation through a profitable system and that the swap is also favorable to you.
The swap will generate a daily plus and in the event that the operation exits by stop loss (loss) it will be less. And if the operation is profitable it will be greater. It is a plus in our operations.
6.3. More medium-long-term vision
Keep in mind that the time in this type of operations is in your favor so keep in mind that these operations are not short-term and that they are designed to get the most out of them during their duration.
6.4. A good risk and capital management assessment
As in any other type of trading and operations systems, before opening a trade make sure which is the% of the account that you can lose. Do not be optimistic because the swap is favorable, the operation can go against you shortly after opening it and if you have not measured the risk well you can have a bad time.
In conclusion, tell you that the carry trade is a strategy based on fundamentals that tries to profit from the difference between the interest rates of a currency pair . Therefore, you must be very clear about what interest rates are and what fundamental factors affect them.
It is a long-term strategy so patience is key to obtaining the desired results. Despite being a long-term trade, this does not mean that you can open a trade and forget about it. It is necessary to monitor interest rates and possible changes in rates and monetary policies of the central banks of the currencies involved in said pair.
The currency risk is a critical factor in the carry trade, which is why this strategy works well in periods of low volatility. On the contrary, you should always bear in mind that the carry trade is a trading strategy with high risk in periods of instability like the current one.
However, if the swap significantly affects your operation, you can propose the operation to exploit only the positive swap part.
That it has not been very clear what this carry trade is about? I explain it to you in this video with an example, step by step.