The carry trade is straight forward. Simply, it is interest paid to traders for holding a certain currency overnight. A good example can be seen with Japanese Yen (JPY). Japanese interest rates have been low for over two decades. Interest rates and yields for other currencies-and for some assets denominated in those currencies-such as the USD, have been higher. Traders selling JPY and buying USD for example, earn interest if they hold their position overnight, or for longer periods. This is essence of the carry trade.
Traders/investors look to sell a low yielding currency and buy a higher yielding currency. Indeed, this trade entry comprises two trades. When a trader enters a “sell” (short) on the EUR/NOK for example, they are buying the NOK and selling the EUR. The net difference in the interest rates-a form of arbitrage-is the traders profit, along with any capital gains from the trade. Traders can also take advantage of leverage to increase their potential profits. The main risks are changes in interest rates, and capital losses from price action of the currency pair.
Price appreciation should be the first objective of traders. It would not benefit traders if they earned the incremental daily interest on a trade, but lost capital as a result of being in the wrong direction. Conditions therefore, must favor entry as well as the carry trade. Most carry traders look for currency pairs where interest rates will remain high or go higher with the currency they are buying, and remain low or go lower with the one they are selling. The ideal trades are those where interest rates are stable and are inline with the trajectory or trend of the trade itself. The longer these conditions remain in effect, the longer the trader can stay and reap the benefits of the carry trade. Stability is key.
Interest rates. Central banks will normally increase short term interest rates to stave off or fight inflation, or to attract investment. Central banks tend to cut interest rates to stimulate economic activity or prevent deflation. When central banks raise short term interest rates, assets held in these currencies, yield more. A good example is the AUD. This currency had been very attractive for investors due to a relatively higher yield. Japanese savers for example-accustomed to low saving rates in Japan-would sell yen to buy Australian dollars, benefitting from steady if not spectacular profits. However, Australia’s central bank-the RBA-have cut interest rates repeatedly over the last year, making the AUD less attractive. This reflects overall changes in the carry trade as central banks around the world have kept interest rates near zero. In addition, economic growth as well as inflation are still low by historical standards, with less probability that central banks will raise rates anytime soon. While the U.S. Federal Reserve have stated that rates will likely remain low at least until 2014, a pickup in inflation could alter that timetable.
Rollover. This is the interest paid either to the trader or paid by the trader, for trades held overnight. Most broker platforms list the rollover rates for each currency pair-what it costs to hold and buy...and what it costs to hold and sell. In this way, traders can see what percentage they will make each day per number of standard lots traded. Rollover is also referred to as swap.
Negative interest. When you pay a bank or bond issuer interest for holding your money, you are paying “negative interest.” In forex, negative interest refers to the rollover or swap rate that a trader would pay for buying and holding a currency that yielded less than the one he was selling. Recent buyers of German Bunds are familiar with negative interest as they have chosen to pay for the privilege of owning those bonds. For these investors, the higher yields of Greek or Spanish bonds, are not attractive as these instruments are perceived to have great risk.
Islamic trading accounts. Sharia law dictates that Muslims should not pay or receive interest, so swaps or rollover are forbidden in these trading accounts. These traders cannot reap the benefits of the carry trade. The upside is that they do not incur negative interest costs for holding positions overnight (rollover).
Trading Platforms. Whether a trader uses MT4/MT5, Trading Station, or a Bloomberg or terminal, the rate of interest (positive and negative) will be shown. On some platforms, it is called rollover, while on others it is referred to as swap. Rollover rates and swap vary from broker to broker. Commodities like gold (XAU) and silver (XAG) do not pay interest and are not viable for the carry trade.
Trading strategy. A carry trade fairs best aligned with direction of the trend. All trades should make sense strictly from a capital gain standpoint, with interest a secondary goal. Interest rate projections as well as changes in GDP and inflation, are the most important indicators as well as the main risks. Inflation can diminish returns, and is important for those in the carry trade to consider when calculating real returns.
Long Term Trend. The Rolling Stones song, “Time Is On My Side,” is a good anthem for carry traders. To realize the highest benefit of interest bearing currencies, traders want to stay in their trades as long as feasible, and accumulate daily interest payments. This means the optimal strategies for carry traders are those with a longer perspective. Often, carry traders will hold positions for months or years.
The Players. Large banks are the biggest players in the carry trade. Indeed, a substantial portion of their trading profits are derived from interest rate spreads. The carry trade also attracts savers, particularly those that receive income from low yielding currencies. Indeed, some retirees participate in the carry trade since bank interest and bond yields often do not pay enough for them to sustain their lifestyle.
Projections. Recent U.S. Federal Reserve statements suggest that they will keep rates low for an extended period, perhaps as far out as 2015. Global economic growth expectations have also been lowered by the IMF so interest rates will probably not rise-even in faster growing emerging market economies-for some time. In addition, there is a convergence in interest rate policies across many economies which could shrink some of the yields that make the carry trade less attractive.