The technique of carry trade is one of the most known and used in the world of finance. Most institutionals and funds used it. Indeed, it is a simple way to make money. The method is as follows: It consists of having debt in a currency with low interest rates and invests the funds borrowed in a currency whose interest rate is higher. It’s a way to take advantage of the gap between two interests rates of two different currencies, that is called interest rate differential.
For example:
The interest rate of the FED is currently at 0.5%. So you borrow dollar heavily to place these funds into an obligation, for example, which give you a profit of 4.5%/year. Your gain on the year is easy to calculate: 4.5% -0.5% = 4.0% You win 4.0% per year. It is the interest rate differential. This fact doesn’t make crazy ... 4% is not enough for you, you can probably earn more by doing your small trades on the market ... you're right it is very possible but imagine now that you applied the technique of carry trade on the forex market, with its enormous potential of leverage ... ahh, i sense you more concentrate!
The carry trade on the Forex : Notice
On the Forex market, we trade currency pairs, such as EUR/USD. When you’re buying Euro, you sell Dollar. You pay interest on the currency you are selling (USD), and collect interest on the money you are buying (EUR). Every evening, at the end of the day's trading, brokers credit or debit to your account interest rates differential on all pairs which you are in position. That's right the real advantage of the Forex to apply the technique of carry trade, every day your broker performs this calculation. Over the year, if the differential between the Euro and the Dollar is 4% for the Euro and you bought Euro, you will receive 4% of the amount invested. This does not change anything you will tell me? Well yes in fact, and that is where the leverage come out. On the Forex, it is possible to trade more than you have on your account, thanks to your broker. Trade with a lot of 100000E with a leverage of 100:1 (or 1000E to open your position) on the EUR/USD and you will receive 4% of 100000E either 4000E!
Of course, this is only in case which the price of EUR/USD has not changed over the year. The price is your entry price on the market when you bought the EUR. Very unusual! There are two other possibilities:
The price has fallen and your broker cut your position and in this case you lose your available margin. It remains you only your 1000E that allowed you to open your position. Ouch!!
The price has gone up in this case you win not only the interest rate differential (4000E) but you also take profit of a higher price. Jackpot!!!
This is for that reason that carry trade lead to a significant devaluation of the currency with low interest rates. Indeed, everyone sell the currency to the profit of currency with high interest rates to take advantage of the interest rate differential. This happened in a first step on the yen, whose rate was 0.50% to the profit of the euro and U.S. dollar, which had a high interest rate.
It is therefore important to choose the currency pair on which you want to make the carry trade. The best thing to do is, as you understood, on a pair on which you will analyze the price at the end of the year, at a price more favourable for you, according to the side of your trade.
Risks of carry trade
As quoted in the example above, the risk of carry trade is the value of the currency you are selling, in the example it was USD. If the USD goes up, the profit made by the interest rate differential may not be sufficient to cover the increase of the USD. You will normally cut your position and you will lost a lot of money, the EUR/USD price having fallen heavily. That is why it is important to work with stop loss to limit your risk. If your stop loss is reached, of course you lose your risk but you still receive the interest rate differential, depending on the length of your position.
The second risk on the carry trade is the evolution of interest rates on currencies traded. If it moves against you, you can lose a part of the interest rate differential which can highly affect your profit.
To take an extreme example:
The interest rate of the FED is currently at 0.5%. The ECB’s rate is at 2.5%. You entered long on EUR/USD to enjoy the interest rate differential. But a few weeks later, the Fed's rate rises to 2% and the ECB’s rate drop to 0.5%. The interest rate differential is now in your disfavor. You pay 1.5% per year instead of receive 2% as previously. If in addtition the USD goes up, you are pretty bad and your losses can be very important. I would tell you to be careful on the technique of carry trade!
To apply the technique of carry trade by limiting your risk at the beginning requires two conditions:
- Find an interest rate differential
- Find a pair with an uptrend on which the currency you are long goes up against the other.
