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Forex: What is a Currency Carry Trade?

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What is a Currency Carry Trade Introduction

Carry is the most popular trade in the currency market, practiced by both the largest hedge funds and the smallest retail speculators. The carry trade rests on the fact that every currency in the world has an interest rate attached to it. These short-term interest rates are set by the central banks of these countries: the Federal Reserve in the U.S., the Bank of Japan in Japan and the Bank of England in the U.K.

Currency Carry Trade

The currency carry trade is an uncovered interest arbitrage (the purchase of securities on one market for resale on another market in order to profit from a price discrepancy).

  • The carry of an asset is the return obtained from holding it (profit or loss).
  • Whilst, pure arbitrages always result in profit; carry trades profit only if nothing changes against the carry’s favour.
  • Investors borrow low-yielding currencies and invest in high-yielding currencies.

The idea behind the carry is quite straightforward. The trader buys a currency with a high interest rate and finances the purchase with a low interest rate currency.

  • WARNING: Before you rush out and buy the next high-yield pair of currencies, be aware that when the carry trade is unwound, the declines can be very rapid and severe. This process is known as carry trade liquidation and occurs when the majority of speculators decide that the carry trade may not have future potential.

Known Risks of the Currency Carry Trade

A risk in carry trading is that foreign exchange rates may change to the effect that the investor would have to pay back more expensive currency with less valuable currency.

  • Carry trades weaken the borrowed currency, as investors sell the borrowed money by converting it to other currencies.
  • I’m sure you’ve read about the undisciplined use of the carry trade during 2008–2012 which contributed to the Icelandic financial crisis (among others). This crisis (simplification) was the result of loans defaulting when the relative value of the Icelandic currency depreciated dramatically, causing loan payment to be unaffordable.

There is some mathematical evidence in macroeconomics indicating that larger economies have more immunity to the disruptive aspects of the carry trade mainly due to the sheer quantity of their existing currency, but, as a currency appreciates there is pressure to cover any debts in that currency by converting foreign assets into that currency. This can accelerate currency valuation changes and cause large exchange rate swings or even a carry reversal.

  • The carry trade is often blamed for rapid currency value collapse and appreciation.

Currency Carry Trade Example

Lets take an example  strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate.

A trader borrows Japanese yen, converts the funds into U.S. dollars and buys a bond for the full amount. Assume the bond pays 5% and the Japanese interest rate is 0%. The trader stands to make a profit of 5% as long as the exchange rate between the countries does not change.

  • If the trader uses a common leverage factor of 10:1, then a profit of 50% can be made. This leverage is commonly used in real estate transactions.

World Interest Rates

The big risk in a carry trade is the uncertainty of exchange rates, if the U.S. dollar were to fall in value relative to the Japanese yen, the trader would run the risk of losing money.

  • As, these transactions are generally done with a lot of leverage, a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.

Also, if U.S. interest rates were to increase this would diminish the value of the bond.

Leveraging Returns

The Forex market offered tremendous leverage, often as high as 100:1. This means you could control $1,000 worth of assets with as little as $10 of capital. However, leverage can be a double-edged sword; it can create massive profits when you are correct, but may also generate huge losses when you are wrong

  • Leverage is most commonly used in real estate transactions through the use of mortgages to purchase a home.

The idea of leverage in the FX market has been under intense debate in recent years. Since the market is decentralized and worldwide, regulation was largely absent from the FX market, but in 2010, the National Futures Association instituted some major changes, one of them being a cap on leverage at 50:1.

What is a Currency Carry Trade Conclusion

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Well, I hope you found something useful and enjoyed this article, What is a Currency Carry Trade. Don’t forget to let me have your thoughts in the comment box below. See you soon.

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