The carry trade is one of the popular trades in the FX market. This potentially lucrative form of trading involves selling a currency with a low interest rate and buying a currency with a higher interest rate and earning from the interest rate differentials. This can be traded using as much or as little leverage as the trader feels suits his risk appetite.
For many years now, carry trades involving selling the Japanese Yen have been very popular due to Japan having a low central bank rate for many many years. In fact, Japan had 0% interest rates between 2000-2006 to try and help their poorly performing economy, this of course was highly attractive for carry traders. Today they are at 0.5%, still very attractive when we look at the central bank rates of many other countries:
* New Zealand 8.25%
* Australia 6.5%
* United Kingdom 5.75%
* United States 5.25%
* Canada 4.5%
* Eurozone 4%
* Japan 0.5%
Currently, The New Zealand Dollar (NZD) really stands out. If we wanted to do a carry trade that involved buying New Zealand Dollars and selling Japanese Yens there would be a 7.75% interest rate differential (8.25%-0.5%). This mean if we bought NZ$10,000 and sold the equipment number of yens, the trade would earn NZ$775 over a year. However, In reality we do not get this exact rate, the brokers take a slight cut and there are other factors too. I am sure some people find 7.75% per year attractive whilst other people may seek much higher returns in a trade off for greater risk. This is where leverage comes in. Many FX brokers nowadays allow very high amounts of leverage, I have seen upto 500:1. I will start writing about the risk factors involved in the carry trade before I go into detail about leverage, it will become clear why if you read on.
As with all FX trading there is considerable risk in the carry trades. When we buy our New Zealand Dollars and sell our Yens we are taking the risk on the currency pair NZD/JPY. Historically this pair has been on a strong uptrend until July 2007, so your carry trades would have earned the income from the interest rate differentials as well as the appreciation of value of your New Zealand Dollars against the Yen. However, with carry trades, there is always the risk of a major carry unwind. This where a huge number of carry trades are closed and the money goes back into japan. Historically, there have been a number of very major carry trade unwinds. The most obvious recent one was in July 2007. On the 22nd July 2007 the NZD/JPY rate was around 97. On the 17th August the rate hit 74.25. A huge drop. If had invested those NZ$10,000 at the top, they would only be worth around NZ$7600 at the bottom. A huge loss.
Trading the Carry Trade using leverage can be highly profitable. For example if you traded the NZD/JPY carry trade with 4:1 leverage, you would earn 4 times the income from the interest rate differentials, which would equate to around 30% in a year. However, the currency movements would affect you 4 times as much, both up and down. For example if price went from 60-90 during your carry trade. That would be a 50% gain. However, if 4:1 leverage was used it would be four times that, 200%. Now lets look at the recent occurrence where the nzd/jpy carry trade went from 97 to around 74.25 in a very short time. This is around a 24% loss, multiply this by 4 and it equates to a 96% loss. This would probably result in a margin call from your broker resulting in most of your account being lost. It is very important to fully understand the potential risks and rewards before acting live carry trades.
Some people prefer to trade GBP/JPY or EUR/JPY instead, the differential is currently smaller but swings tend to be considerably less in percentage terms.
On a final note, most FX brokers pay the interest differentials on a daily basis. If you use an MT4 broker, there is a SWAP section in your terming showing your open positions, this is the interest you have earned. If you open a position with negative interest rate differentials (e.g. A short nzd/jpy) you will have to pay the interest rather than receive it.
In Conclusion, The carry trade is a potentially lucrative way of trading/investing, however it is not without considerable risks, especially when traded with a large amount of leverage.
In Conclusion, The carry trade is a potentially lucrative way of trading/investing, however it is not without considerable risks, especially when traded with a large amount of leverage.
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