Thursday, April 29, 2010

What is Carry Trading?

The term Carry trading unless otherwise specified denotes currency carry trading. Carry trading is one of the Currency trading strategies which is the most popular strategy currently being used by professional currency traders as well as less seasoned traders. The main reason why carry trading is gaining a pace is the interest rates differences existing in different countries. 

Unlike other currency trading strategies which are focused towards trading different pairs of currencies with a motive to earn a profit resulting from the changes in exchange rates in carry trading the main focus is to take advantage of different interest rates prevailing in different markets across the globe. The most attractive avenue for carry trading are the currency pairs having minimal changes in exchange rates & having substantial interest rate disparity prevailing in respective countries.

A currency carry trade is a trade in which the investor borrows the currency of country which is having low interest rate & invests in the currency of the country having comparatively high interest rates.

In recent past the Japanese Yen was mostly used in carry trades due to very low interest rates in Japanese markets.

Example of A Currency Carry Trade:

Suppose an investor borrows Japanese Yen 1,000,000 with an interest rate of say 1 percent. Now the investor would convert (sell) the JPY to USD say $10,600. This $10,600 he would use to invest in a U.S. Bond that pays 4 percent as interest. The investment in bonds would earn an interest income of $424 & the interest on JPY 1,000,000 that he needs to pay would be JPY 10,000 or $106. This trade would earn the investor a net profit of $318 ($424-$106) which is 3 percent on investment. This profit is earned without any movement in USD/JPY exchange rate. As compared with normal currency trading involving currency pairs the carry trading offers more reliable returns.

The above example is a simplified version of actual carry trades happening in markets for the ease of understanding of readers. In practice usually the investor would use leverage ratio to buy higher amounts of JPY with the same amount of USD & the profits would be huge.

A word of Caution

The carry trade essentially differs from an arbitrage in the sense that in arbitrage the returns are guaranteed which is not the case in carry trade. The returns in Carry trade are not guaranteed because returns are dependent upon the exchange rate fluctuations. In our example above if Japanese Yen would have appreciated the investor may suffer losses or in fact he may lose his money. So before doing any carry trading you should collect all the relevant data & should use your discretion while investing. Also carry trading is a long term strategy & it is not for intra day speculations.

What makes a Carry trade Successful?

  •         Exchange rate stability:
The success of carry trade would highly depend upon the exchange rate stability of the currency pairs involved. Higher the stability higher would be the possibility of making a profit & vice a versa.

  •         Economic Conditions:
Before entering into any carry trades you should study the underlying economic conditions of the economy you would be investing in. Higher interest rate doesn’t always guarantee a good profit but in many cases like of hyper inflation caused not due underlying economic activity in fact may endanger safety of your capital.

  •         High Interest Rate disparity:
Higher the interest rate difference between the countries higher would be the profitability of carry trading vice a versa.


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Anonymous said...

Very good article. Very good analysis. I have seen few article explaining the concepts in easy to understand language. Well Done.!