What is carry trading?
A carry trade strategy involves a trader investing in a high yield instrument, which is financed by borrowing in a low yielding instrument. Carry trades can involve many types of instruments. It can include investments in low-grade bonds, which are financed by borrowing in high-grade bonds. However, the most popular carry trades throughout history have mainly been in the forex market. Here carry traders invest in high-yielding currencies using funds provided by borrowing low-yielding currencies. A classic example of this would be investments in AUD, financed by borrowings in JPY.
Understanding the mechanics behind carry trading
The eight major currencies and their upper-bound overnight rates, also called benchmark or cash rates, are NZD (1.75%), AUD (1.50%), USD (1.50%), CAD (1.00%), GBP (0.50%), EUR (0.00%), JPY (-0.10%), and CHF (-0.75%).
However, as you must know, the actual rates offered by brokers can be different from the ones stated above. For example, the rate above suggests that annual carry from an AUD/CHF trade is 2.25%, as obtained from 1.50% – (-0.75%), but an individual broker may offer just 1.05% spread.
If you want to purchase a standard lot of AUD/CHF, for example, 100,000 units of the base currency, the daily interest accumulation would come to the 2.75% spread divided by 365 and multiplied by the notional amount, which would be about $7.53 per day. Keep in mind that it is the result if you purchase a standard for designated in US dollars.
For those who are short the AUD/CHF, interest is daily paid, just as someone who shorts a stock would pay the dividend, if applicable.
Low-interest rate environment
In 2020, the world is circulating around low-interest rates. So, carry trading does not offer as much return among major currency pairs as before. Due to this, many individuals interested in carry trading have to take the risk and borrow a major cheap currency to purchase a higher-yielding emerging market (EM) currency.
They do it to earn a yield beyond the higher-duration US treasury bonds. You need to know that EM currencies are more volatile. So, they are risky to trade. Moreover, they underline jurisdictions exposed to the less robust rule of law, political instability, poor institutions, corruption, lack of private property laws, low levels of investment and innovation, and undeveloped debt and capital markets.
During carry trading, if you are long the higher-yielding currency compared to the lower-yielding currency, interest is daily accumulated. The Forex market is active 24/5. So, to compensate, interest is acquired three times the general amount on Wednesdays.
Currencies used in forex carry trading
As mentioned earlier, the Forex carry trading widely means borrowing a cheap currency like the Swiss Franc (CHF) or the Japanese Yen (JPY) and purchasing either a higher-yielding currency like Turkish Lira (TRY) or Mexican Peso (MXN) or another financial asset.
Currencies are considered low-yielding or high-yielding based on interest rates. Central banks of central countries or jurisdictions can raise or lower short-term interest rates and ensure price stability and employment levels according to their statutory mandate.
Among the major currency pairs, AUD/CHF and AUD/JPY are the most popular options for carry trading. In these currency pairs, AUD is the high-yielding currency, while CHF and JPY are the low-yielding currencies. If one shorted the AUD/JPY, interest would be paid daily. On the contrary, if one were long the pair, interest would be earned daily.
Risks of carry trading
Carry trading may seem a great strategy to profit from forex trading but note that this strategy has a substantial potential for loss as well. Here is a list of the common risks associated with carry trading.
Carry trades are usually held unhedged, which means that any return from the interest rate differential is required to be in excess of any adverse exchange rate movements in the carry trading currency pair. As a result, the currency pair is generally chosen for the carry trade that the trader forecasts that the higher rate currency would appreciate over the predetermined time frame relevant to the lower interest rate currency. The trader may make this forecast according to a suitable combination of fundamental and technical analysis because it is generally for a very long timeframe.
A crucial risk factor for retail forex traders employing carry trading is that with substantial leverage being used in this strategy, sharp unfavorable market movements may result in losses, leading to margin calls or the position being stopped by your forex broker automatically.
Interest rate shift risk
When traders with the carry trading strategy aim to compound their interest on a daily or monthly basis for increasing their overall returns, they can be subjected to the returns varying with the movements in the interest rate differential. For instance, if the interest rate differential widens, the move will usually be in favor of the carry trader, and they can take advantage of it in the next compounding period. On the contrary, when interest differentials narrow, the trader is going to receive a lower return than expected in the next interest compounding period.
Emerging markets risk
This risk arises due to the numerous carry traders being present in emerging market currencies. A crisis in any single currency can carry over and cause additional chaos in other markets. For instance, there have been cases in the past when the financial breakdowns in Mexico, Thailand and Russia, spread to neighbouring countries.
Like any strategy, carry trading implies the potential wins and losses that you are now aware of. As with any strategy, losses are inevitable, but if you are careful with the risks of carry-trading and avoid those when you can, that will help you minimize the losses.