In this blog, we will learn about the Forex Carry Trade Strategy, through various examples and understand the various aspects of the Carry Trade Strategy.
We'll cover:
- What is Carry trade?
- Why only the Forex market?
- What do we earn in this trade?
- Arbitrage opportunity
- Uncovered/Covered Interest Rate Parity
- Formula for Interest Rate Parity
- Pitfalls for Interest Rate Parity
- Common FAQs in Forex Carry Trade
Let's begin! Simple forex carry trade strategy is where the funds from the high-yielding currency rate are invested in low-yielding currency rate to leverage the difference between forex rates.
There are a lot of questions that pop up when we read the classic definition.
- Why the word Carry?
- Why only in the Forex market?
- What do we earn in this trade?
- Isn’t this arbitrage opportunity?
- If it is arbitrage, would there be more risk?
Let’s take a step back and answer one at a time.
What is Carry trade?
The word Carry means the returns we obtain for holding an asset. When we ‘Carry’ commodities for a long time, we end up with negative returns as they incur storage costs. But this is not the case in the Forex market. We do not actually Carry any physical entity.
What is Carry Trade Strategy in Forex? Why only the Forex market?
The carry trade strategy is not finite to the forex market. It is popular in the forex market as the difference in currency rates exist in the market quite often. Up until the Global financial crisis, these trade strategies generated persistent positive returns.
In 2008 these trade strategies blew up which weakened the case of predictable forex returns. For example, the USD/JPY exchange rate took almost 5 years to recover after the crisis in 2008.
Despite the above risk, you can always leverage this strategy provided you did decent market research before investing.
What do we earn in carry trade strategy?
In carry trade strategy you earn the interest. When you take a long position in the currency you are gaining the interest and when you take a short position you are paying the interest. The difference in the interest rates multiplied buy your notional is your profit. For example, let’s take one of the most traded forex currency EUR/USD. As of today, the LIBOR interest rates of USD and EUR are as follows.
- USD - 2.379 %
- EUR - -0.476 %
Suppose we took a short position in EUR/USD currency with a notional of 100,000 dollars. The interest can be calculated as follows:
In our case,
This amount might differ because of the daily fluctuation in the overnight LIBOR rates. And if you have taken a long position in EUR/USD, you would have ended up paying the exact amount.
Is this an arbitrage opportunity?
There are few concerns regarding the forex trading strategy. This strategy disobeys the risk-neutral efficient market hypothesis as it is clearly an arbitrage opportunity in the forex market. Also, people see it as a failure of uncovered interest rate parity. Before clearing up this misinterpretation let’s see briefly what interest rate parity is.
Uncovered/Covered Interest Rate Parity
- The theory states that the differential of interest rates between two countries is equal to the differential between the forward exchange rate and the spot exchange rate of the two countries.
- Unlike covered interest, uncovered interest involves no hedging of foreign exchange risk with the use of forwarding or any other contracts.
The formula for Interest Rate Parity
(1 + Interest rate in Domestic currency) = (Spot foreign exchange rate / Forward foreign exchange rate) * (1 + Interest rate in Foreign currency)
But what we miss here is that the Interest Rate Parity (IIP) is based on forecasted results and not on actual results. IIP is an ex-ante, not an ex-post condition. So forex trading strategy does not fail any existing theories.
Pitfalls for Interest Rate Parity
Although earning interest and making a profit seems easy in the forex carry trade strategy, there are some pitfalls one should be aware of.
Central Bank reduces interest rates.
In the above example, we have seen that a difference in interest rates makes you profit. But the interest rates keep changing. When Central Bank reduces interest rates and you did not change your position accordingly, the profit you are making might turn into losses.
Central Bank Intervenes in Currency.
To increase or decrease a nation’s currency Central Bank will buy or sell in the forex trading market. By doing this the value of the currency might increase or decrease accordingly against the alternative currency.
Leverage used.
The leverage used by the carry traders can make the trade risky. Even a small dip like 10% in a currency pair along with 10% leverage might wipe out the whole capital of that trade.
FAQs in Forex Carry Trade Strategy
Here are some of the most frequently asked questions about Carry Trade Strategy in Forex:
1. How to choose currencies in the forex market?
Ans: If you are new to the Carry trade strategy, we would recommend you start with the less risky currencies. G7 currencies would be a good start. Currencies from the emerging markets, do offer higher yield but very sensitive to small changes in the financial system and riskier, to begin with.
2. What are the factors that affect currency prices?
Ans: The are multiple factors that affect currency prices. These are discussed in more detail in our Forex market trading factors blog. The factors are as follows:
- The Political Landscape
- Inflation Rate
- Interest Rate
- Government Debt
- Terms Of Trade
- Speculation
- The Capital Market
- Employment Data
- Economic Planning
3. What is a PIP, a commonly used term in the forex market?
Ans: If you are working in the forex trading strategies market then you will hear of this term very often. PIP is a short form for the ‘point in percentage’. It is the smallest measure of the change in a currency pair in the forex market. Most of the currencies in the forex market are priced until the fourth decimal.
For example, the smallest change in the USD/AUD currency pair is $0.0001. This is equal to 1/100 or 1% or one basis point. This is helpful when you are using currency pairs for hedging in your portfolio. Hedging in forex market eats up in both positions and it increases significantly for a small change in the spread.
How to be successful in forex carry trade strategy?
To be successful in forex carry trade strategy we should know when to get in and when to get out. Best time to get in would be when there is a piece of information from central banks about increasing rates in a country and once there is a spur about the news and more people start investing you should make optimal returns and exit from that particular forex rate. Traders sometimes reverse their positions if they see a big opportunity.
Conclusion
As per the above-gained knowledge in forex carry trade strategy, it should be the investors' favourite strategy which gives positive returns forever. Unfortunately, this is not what we observe in the market. The positive side of the existing differential in forex rates makes it riskier with time.
As these are actual opportunities existing in the market and evident for most of the people makes everyone go after them and makes it riskier. The interest rate of a country which we buy to take advantage of the differential increases as more people buy it. Especially during a crisis, the market moves very quickly and leads to large negative returns.
One example would be the movement in YEN currency during the Global financial crisis in 2008, up to 30% movement against GBP currency in 5 hours. So it is advised to be careful and take precautions such as implementing a Stop/Loss strategy.
You can learn more about the forex market and create strategies in the same by enrolling for our course on Forex Trading Strategies in Python. Happy Trading!
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