When considering taking on a carry trade position, a forex trader will first want to take into account the interest rate differential and their forecast for the currency pair over the desired time frame for the carry trade.
If both of these elements look favorable for the trade, then the next factor they might want to consider will be the effect of compound interest on their trade.
The following sections will focus on the carry trade and how compound interest affects its success.
What is the Carry Trade?
The so-called carry trade has become quite popular with hedge funds and other large currency speculators. The transaction is often done in quite large amounts to produce attractive returns for these traders, although it may not be worthwhile for retail currency traders dealing in smaller sizes.
In general, the carry trade involves going long a currency with a high interest rate and short a currency with a low interest rate. The position will then be held for an extended time frame to take advantage of this interest rate differential.
A typical forex carry trader will also generally seek to identify a currency pair that they forecast to have an exchange rate movement during the carry trade period that favors the higher interest rate currency.
Popular carry trade currency pairs involving major currencies include: AUD/JPY, NZD/JPY, AUD/USD and EUR/JPY.
Carry Trade Risks
While carry trades might seem an attractive way of profiting from your forex trading activities and wide interest rate differentials between currencies, be aware that these trades also have a substantial potential for loss, as well as profit.
The following list includes some of the primary risks commonly associated with carry trades.
- Currency Risk
Since carry trades will generally be held unhedged, this means that any return from the interest rate differential needs to be in excess of any adverse exchange rate movements in the carry trade currency pair.
As a result, a currency pair will usually be chosen for the carry trade for which the trader forecasts the higher interest rate currency will appreciate over the chosen time frame relative to the lower interest rate currency.
The carry trader might make this forecast based on a suitable combination of technical and fundamental analysis, since it will usually be for a fairly long time frame.
- Leverage Risk
An important risk factor for retail forex traders to consider with the carry trade is that if substantial leverage is used to implement it, then sharp unfavorable market movements could result in losses that may prompt margin calls or the position being automatically stopped out by your forex broker.
- Interest Rate Shift Risk
When carry traders seek to compound their interest on a monthly or even daily basis to increase their overall returns, they can then be subject to returns that can vary depending on movements in the interest rate differential.
For example, if the interest rate differential widens, this will generally be a move in the carry trader’s favor, which they can take advantage of in the next compounding period.
On the other hand, when interest rate differentials narrow, the carry trader will then receive a lower return than anticipated in their next interest compounding period.