Carry trade means selling low-yield assets to buy high-yield assets

 

Carry Trade Investing Strategy

Carry trade is a very popular Forex investing strategy that involves borrowing or selling a Forex currency with a low interest rate, and a t the same time buying a Forex currency with a higher interest rate.

 

Introduction to Carry Trade

In general, carry trade means borrowing in a low-interest rate Forex currency and investing in a higher interest rate currency. The profit mechanism is simple, you are paying a low interest (borrowed currency) while you are collecting a higher interest rate (purchased currency). Hence, the profit is the product of the interest rate differential.

At a glance:

□ Carry trade means selling low-yield assets to buy high-yield assets

□ Typical carry trade funding currencies are the Swiss franc (CHF), and the Japanese yen (JPY)

□ Two common pairs for carry trading are AUD/JPY and AUD/CHF

□ Profiting from the interest rate differential

□ The risk includes the general exchange rate risk (market risk)

 

Why Carry Trade Works?

The interest rate is part of each Central Bank’s monetary policy and reflects the expectations for inflation, unemployment, and growth. Therefore, different macroeconomic conditions create the need for different levels of interest rates. More specifically, these are some common reasons for higher/lower interest rate monetary policies:

(↑) Higher Interest Rates

□ Deal with increasing inflation (by limiting money supply)

□ Limit growth (in case of an overheating economy)

□ Deal with a capital shortage (by making a currency more attractive to foreign capital)

□ Deal with a financial or other turmoil that caused a currency devaluation

(↓) Lower Interest Rates

□ Deal with high unemployment (by motivating real investment)

□ Stimulate the economy and growth (by motivating consumer spending)

□ Limit domestic currency appreciation

Note: The zero interest rate policy “ZIRP Policy” applied by a great number of central banks in developed countries has created several opportunities for carry trading in the Foreign Exchange market.

 

The Carry-Trade Mechanism Explained

As all Foreign exchange currencies are traded in pairs, each pair includes two different interest rates. As mentioned above, when you take a position on a Forex pair you pay interest on the currency you sell and collect interest on the currency you buy.

That payment is made on a daily basis, at midnight. Depending on your broker’s time server, that may happen for example at 00.00 GMT or 00.00 GMT+2. Technically, all trading positions are closed at midnight and are paying or collect an interest rate. The next day (after midnight) all positions re-open.

□ No Rollover Rate is paid during weekends

□ On Wednesday, the Rollover Rate triples (X3) to cover the two days of the weekend

□ On a holiday, no Rollover Rate is paid

□ The day prior to the holiday, the Rollover Rate may be doubled (X2) or even be tripled (X3)

□ The Rollover Rates may change at any time, but basically moves accordingly the interest rate decisions by the Central Banks

 

 

Using Leverage on Carry Trade Positions -The Untold Hazard

The ability for trading leverage available in the Foreign Exchange market makes carry trade very popular. The ability to leverage a position means the interest rate differential can become quite significant.

If we consider that the average carry trade return (without leverage) is around 3-4% on an annual basis, Forex investors are usually willing to apply trading leverage in order to earn more.

Carry trade and high leverage sounds an opportunity, but actually it can easily turn bad for traders. A carry-trade position means exposure in the market for long periods. If a trader uses leverage 20:1 means that if an exchange rate moves 5% unfavorably his positions will be forced to close. Therefore, wise carry-traders do not leverage their positions more than 5:1.

□ The interest rate differential becomes quite significant via the use of trading leverage

□ Leverage magnifies the exchange rate risk

□ The use of trading leverage on carry-trade positions should not exceed 5:1

The Chain Reaction

A large negative, but not necessarily extreme, shock to the carry trade portfolio could be amplified by a chain reaction of leveraged and funding-constrained traders forcefully unwinding their positions (particularly during times of low liquidity). This, in turn, puts further pressure on exchange rates and triggers more forced unwinding, thus culminating in a spiral of losses, i.e. a crash. {Valeri Sokolovski (1)}

As Malcolm Knight, Managing Director of the Bank for International Settlements, said (2007):

“We have some very crowded trades in some areas now… and leverage is increasing. Taken together, this leverage and carry trades create the prospect that we could have rapid repricing in financial markets."

In other words, when a carry-trade is too obvious, then Forex investors should be fearful to use high leverage. The reason is that many others will do the same. If something goes wrong, a lot of carry traders will close their positions simultaneously, creating a chain of events that could end on a rapid exchange rate repricing against the vast majority of carry traders.

According to Mr. Sokolovski (1): 40% to 50% of the most extreme carry trade drawdowns occur following periods that are identified as having the highest levels of carry trade crowdedness. The carry trade crowdedness measure retains its significant predictive ability.

 

General Conditions for Successful Carry Trade

These are some general conditions for successful carry traders:

(1) Entering at the Beginning of the Interest Rate Cycle

As mentioned earlier, carry trading is very effective when central banks increase or plan to increase the level of interest rates. The key to carry traders is to enter at the beginning of the interest rate cycle.

(2) Timing Carry Trades by using Technical Analysis

Even though carry traders are fundamentalists, they should always take a look at technical analysis charts. A carry trader follows long-term trends, and in that sense, he needs to perform chart analysis. Carry traders don’t want to trade against the master trend, neither to enter a market that is about to correct unfavorably.

(3) Use Trading Leverage with Extreme Caution

Carry traders can use capital leverage to earn higher profits. Nevertheless, as mentioned above, using capital leverage means also accepting higher risks. A general approach is to adjust the rate of capital leverage to deal with the incurred volatility. In any case, the leverage on carry trades should never exceed 5:1.

  • Higher volatility → lower capital leverage
  • Lower volatility → higher capital leverage

(4) Low-Volatile Assets are Preferable

Carry trades are more effective in a low volatility environment.

  • Low-volatile assets have more predictable returns than high-volatile assets

(5) Avoiding Carry Trade Crowdedness

As mentioned above, 40%-50% of the most extreme carry trade drawdowns occur following periods that are identified as having the highest levels of carry trade crowdedness

 

 

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Resources:

  • Crowds, Crashes, and the Carry Trade {Valeri Sokolovski, HEC Montreal, May 3, 2019}