Real versus Nominal Interest Rates
Let’s suppose I have some euros and if I deposit them at the bank for 1 year, they will give me a return of 3%. This is the nominal interest rate. What this means is, after 1 year I will get back 3% more euros than I put in. Yet if inflation is 1%, this means I can only buy 2% more stuff with those euros. I have only really gained a return of 2%. This is the real rate of interest. What if we expect the interest rate of EUR to increase to 4% in 6 months, but inflation stays about the same? If GBP stays the same, this means that the yield advantage between GBP and EUR will disappear after 6 months. That would likely cause the EUR/GBP exchange rate to rise because now I can only gain my 1% additional return for six months instead of one year
Why do currencies’ value change over time?
Currency trading is all about supply and demand supply and demand of money. A currency’s value against another currency increases because demand is greater than supply at a certain point. A currency’s exchange rate may rise and fall with interest rates, but the interest rates are rising and falling in response to changes in demand and supply and the driver of this is general economic conditions. When demands for capital are high as in a growing economy the real interest rates have to rise as well. Both corporate and government debt has to offer a high enough real return to be able to attract capital. Otherwise, funds will flow to other better yielding assets such as stocks or foreign investments
What is Carry Trading?
In the financial dictionary, the “carry” of an asset is the return obtained from holding it. So, a carry trade involves buying a currency and “carrying” it until you make a profit. In its basic form, carry trading is a strategy for profiting from the difference in interest rates between two currencies. In principle “cheap money” is borrowed, converted to another currency, and lent out at a higher rate of return. The trader then earns profits from the cash flows since most forex traders use leverage, and the carry trade can offer a substantial income yield. Though, this isn’t without risks. The basic aim of the carry trade is to borrow a currency with low interest and lend a currency with a higher interest. This results in a positive cash flow. Any due interest is paid to the trader for as long as the position remains open. The carry trade can be implemented in many ways. One can use currency forwards, bank deposits, local currency sovereign bonds, or local currency corporate bonds
When trading the forex market traders trade on margin, or in other words, using leverage. This means that you only need to place a fraction of the full trade value in order to gain exposure to the currency market, which acts as a deposit. Leverage can work in your favor if the trade is successful, but it can also magnify your losses if the trade is unsuccessful. Traders should be cautious when trading on margin and always have a risk management plan to offset as much capital loss as possible.
How to Choose a Carry Trade Pair?
High-carry currencies are those with high prevailing interest rates. In the EM currency universe, the South African rand, Brazilian real, Indonesian rupiah, and Indian rupee have been perennial high carry currencies while the Taiwan dollar, Hong Kong dollar, and Singapore dollar have been traditional low carry currencies. In the last few years, the low-interest currencies favored by carrying traders have been the Swiss franc (CHF) and Japanese yen (JPY), and EURO. Popular higher-yielding currencies are the Australian dollar (AUD) and New Zealand dollar (NZD). There are currencies with much higher yields of course among developing nations, but AUD and NZD are popular because they are the currencies of advanced economies. Let’s assume the base interest rate of the Australian dollar is 4.5%. While the base rate of the Japanese yen is 0.1%. This means there’s a gross interest rate difference of 4.4%. For every day that you have that trade on the market, the broker will pay you the difference between the interest rates of those two currencies which would be 4.4%. Such an interest rate difference can add up over time. To give you an idea a 4.4% interest rate differential becomes 88% annual interest a year on an account that is 20 times leveraged.
Checking Swap Rates using MetaTrader
If you use MetaTrader, you can easily check the swap rates by right clicking in the “Market Watch” window. Select your chosen currency pair, and then click on the specification. The long/short swap values are given there usually in points.
ments can provide a steady income stream in a carry trading system. But the trader still has an exchange rate risk. That is, the risk that the underlying currency exchange rate will change and cause a loss on the trade. For example, by 2007 the carry trade involving the Japanese yen had reached $1 trillion as the yen had become a favored currency for borrowing thanks to near-zero interest rates but as the global economy deteriorated in the 2008 financial crisis, the collapse in virtually all asset prices led to the unwinding of the yen carry trade. In turn the carry trade surged as much as 29% against the yen in 2008, and 19% percent against the U.S. dollar by 2009. For this reason, many carry traders implement a hedging strategy to protect them against these losses.
Carry Trading Strategies
The basic carry trade strategies are:
- Buy and hold – one or more positions are held for the long term
- Hedged – exchange rate risk is reduced or eliminated altogether.
- Buy and hold Strategy
Buying the high interest rate currency such as AUD or NZD and Sell low interest rate currency such as JPY or EURO and hold it until interest rate difference change
- Hedged Strategy
The ultimate carry trade hedging strategy is not to have any exchange rate risk at all. the trader holds a position to accumulate interest. The exchange rate loss or gain is something that the carry trader needs to allow for and is often the biggest risk. A large movement in exchange rates can easily wipe out the interest a trader accrues
- A- Reverse carry pair hedging
Holding a carry pair to mitigate this risk, the carry trader can use something called Reverse carry pair hedging the pair chosen for the hedging position is one that has strong correlation with the carry pair but crucially the swap interest must be significantly lower.
- B- Carry Hedging with Options
One hedging approach is to buy “out of the money” options to cover the downside in the carry trade. The reason for using an “out of the money put” is that the option premium (cost) is lower but it still affords the carry trader protection against a severe drawdown.
- A- Reverse carry pair hedging
- Buy and hold Strategy
Carry Trade Strategies returns
After adjusting for risk, some research suggests that the carry trade typically outperforms stocks. The Bloomberg Cumulative FX Carry Trade Index, which tracks the performance of eight emerging-market currencies versus the dollar, has had positive returns in 12 of the past 20 years
The content published above has been prepared by CFI for informational purposes only and should not be considered investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.