In general, the forex trading strategy known as the “Carry Trade” refers to an increasingly widespread forex trading strategy that is usually implemented over longer term time frames and involves taking advantage of the interest rate differential prevailing between two currencies.
Furthermore, using such an interest rate strategy in your forex trading will make the most sense if you use a forex broker that provides particularly attractive rates on rollovers for the currency pair you are most interested in putting on a carry trade with.
Profiting From Interest Rate Differentials
Since carry traders basically look to capture the interest rate differential between two currencies, as well as hopefully some additional appreciation from favorable exchange rate movements, they need to choose their pairs wisely based on two primary criteria.
The first is the magnitude of the interest rate differential itself. The absolute value of this differential can be readily computed by subtracting the higher interest rate from the lower interest rate for each currency involved. The interest rates used will be those prevailing for Interbank deposit rates for the time period during which the carry trade will be kept on for.
The second consideration is the likelihood of appreciation of one currency versus the other. Since carry trades tend to be longer-term positions, a combination of fundamental and technical analysis is often used to arrive at this forecast.
For the best carry trade scenario, you will want to choose the highest interest rate currency that stands the best chance of appreciation against the lowest interest rate currency according to your forecast for the future exchange rate over your time frame of interest.
Carry Trade Profits and Risks
Not only do carry traders hope to capture the resulting favorable interest rate differential or “positive carry” as it is often called, but they usually also plan on benefitting from interest rate compounding effects, as well as from any currency appreciation seen.
The sum of these factors at the time the trade is closed out will determine their profit or loss on the carry trade.
In terms of risk management, the interest rate differential provides something of an initial protective buffer against losses that might accrue due to adverse exchange rate movements. Nevertheless, stop losses can be placed at strategic points that stand a reduced chance of being executed as an additional form of risk management. Learn more about the risks with carry trading.
Additional Profits or Costs of Rollovers
Rollovers of currency positions tend to be executed automatically by most online forex brokers if the position is held over the time of 5 PM Eastern Standard Time.
An automatic rollover means that the broker will automatically close out your existing forex position for value spot and roll it forward for value one additional business day in the future. Since rollover rates can vary substantially among forex brokers, make sure you choose a broker with competitive rollover rates if you intend to put on carry trades.
Generally, when forex traders have their currency positions rolled, they will get paid pips to do so if they are holding the higher interest rate currency. On the other hand, if they are holding the lower interest rate currency, they will pay pips away when their position is rolled over.
Hedged Carry Trades
Yet another type of carry trade involves hedging one long carry trade with another short carry trade using different currency pairs that are closely correlated and which results in a net interest rate benefit to the overall position.
For example, a hedged carry trader might exploit interest rate differentials between well correlated currency pairs like the following:
- EUR/USD and USD /CHF
- AUD/USD and NZD/USD
- GBP/USD and USD/CHF
- EUR/JPY and CHF/JPY
- GBP/JPY and CHF/JPY
Such hedged carry trades are often highly leveraged to make them worthwhile, thus much more risky. Nevertheless, the main risk to this hedged carry trade strategy arises if the correlation between the pairs breaks down for some reason and subsequently results in losses. Remember that the correlation risk is of course not the only risk factor to consider, just one of them.
The Effect of Risk Aversion and Appetite on the Carry Trade
When risk aversion prevails among investors in the forex market and exchange rate volatility is high, the carry trade often starts to look less attractive since the riskier currencies to invest in tend to have higher interest rates.
On the other hand, when all seems well in the world and more stability has returned to the currency market, the risk appetite of investors then tends to increase and they start looking for higher returns on their money, even if it means taking more risk.
The Benefit of Compounding Interest
Another interesting element that favors the carry trade is the possibility of compounding your interest on a daily basis by rolling your carry trade positions over each day.
When the rollover spreads available for doing so are reasonably competitive, this can provide even more income for the carry trade compared with just rolling the carry trade position out for an extended period using a forex forward contract.