What is Carry Trade?

Did you know there is a trading system that can make money if price stayed exactly the same for long periods of time?

Well there is and it's one the most popular ways of making money by many of the biggest and baddest money manager mamajamas in the financial universe!

It's called the "Carry Trade".

A carry trade involves borrowing or selling a financial instrument with a low interest rate, then using it to purchase a financial instrument with a higher interest rate.

While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased. Thus your profit is the money you collect from the interest rate differential.

For example:

Let's say you go to a bank and borrow $10,000. Their lending fee is 1% of the $10,000 every year.

With that borrowed money, you turn around and purchase a $10,000 bond that pays 5% a year.

What's your profit?

Anyone?

You got it! It's 4% a year! The difference between interest rates!  

By now you're probably thinking, "That doesn't sound as exciting or profitable as catching swings in the market."

However, when you apply it to the spot forex market, with its higher leverage and daily interest payments, sitting back and watching your account grow daily can get pretty sexy.

To give you an idea, a 3% interest rate differential becomes 60% annual interest a year on an account that is 20 times leveraged!

In this section, we will discuss how carry trades work, when they will work, and when they will NOT work.

We will also tackle risk aversion (WTH is that?!? Don't worry, like we said, we'll be talking more about it later).

How Do Carry Trades Work for Forex?

In the forex market, currencies are traded in pairs (for example, if you buy USD/CHF, you are actually buying the U.S. dollar and selling Swiss francs at the same time). Just like the example in the previous, you pay interest on the currency position you sell, and collect interest on the currency position you buy.

What makes the carry trade special in the spot forex market is that interest payments happen every trading day based on your position. Technically, all positions are closed at the end of the day in the spot forex market. You just don't see it happen if you hold a position to the next day.

Brokers close and reopen your position, and then they debit/credit you the overnight interest rate difference between the two currencies. This is the cost of "carrying" (also known as "rolling over") a position to the next day.

The amount of leverage available from forex brokers has made the carry trade very popular in the spot forex market. Most forex trading is margin based, meaning you only have to put up a small amount of the position and you broker will put up the rest. Many brokers ask as little as 1% to 2% of a position. What a deal, eh?

Let's take a look at a generic example to show how awesome this can be.

For this example we'll take a look at Joe the Newbie Forex Trader.

It's Joe's birthday and his grandparents, being the sweet and generous people they are, give him $10,000. Schweeeet!

Instead of going out and blowing his birthday present on video games and posters of bubble gum pop stars, he decides to save it for a rainy day. Joe goes to the local bank to open up a savings account and the bank manager tells him, "Joe, your savings account will pay 1% a year on your account balance. Isn't that fantastic?"

Joe pauses and thinks to himself, "At 1%, my $10,000 will earn me $100 in a year."

"Man, that sucks!"

Joe, being the smart guy he is, has been studying BabyPips.com School of Pipsology and knows of a better way to invest his money.

So, Joe kindly responds to the bank manager, "Thank you sir, but I think I'll invest my money somewhere else."

Joe has been demo trading several systems (including the carry trade) for over a year, so he has a pretty good understanding of how forex trading works. He opens up a real account, deposits his $10,000 birthday gift, and puts his plan into action.

Joe finds a currency pair whose interest rate differential is +5% a year and he purchases $100,000 worth of that pair. Since his broker only requires a 1% deposit of the position, they hold $1,000 in margin (100:1 leverage). So, Joe now controls $100,000 worth of a currency pair that is receiving 5% a year in interest.  

What will happen to Joe's account if he does nothing for a year?

Well, here are 3 possibilities. Let's take a look at each one:

1. Currency position loses value. The currency pair Joe buys drops like a rock in value. If the loss brings the account down to the amount set aside for margin, then the position is closed and all that's left in the account is the margin - $1000.
2. The pair ends up at the same exchange rate at the end of the year. In this case, Joe did not gain or lose any value on his position, but he collected 5% interest on the $100,000 position. That means on interest alone, Joe made $5,000 off of his $10,000 account. That's a 50% gain! Sweet!
3. Currency position gains value. Joe's pair shoots up like a rocket! So, not only does Joe collect at least $5000 in interest on his position, but he also takes home any gains! That would be a nice present to himself for his next birthday!

Because of 100:1 leverage, Joe has the potential to earn around 50% a year from his initial $10,000.

Here is an example of a currency pair that offers a 4.40% differential rate based on interest rates as of September 2010:

If you buy AUD/JPY and held it for a year, you earn a "positive carry" of 4.40%.

Of course, if you sell AUD/JPY, it works the opposite way:

If you sold AUD/JPY and held it for a year, you would earn a "negative carry" of 4.40%.

Again, this is a generic example of how the carry trade works.

Any questions on the concept? No? We knew you could catch on quick!

Now it's time to move on to the most important part of this lesson: Carry Trade Risk.

To Carry or Not to Carry

When Do Carry Trades Work?

Carry trades work best when investors feel risky and optimistic enough to buy high-yielding currencies and sell lower yielding currencies.
It's kinda like an optimist who sees the glass half full. While the current situation might not be ideal, he is hopeful that things will get better. The same goes for carry trade. Economic conditions may not be good, but the outlook of the buying currency does need to be positive.
If the outlook of a country's economy looks as good as Angelina Jolie, then chances are that that country's central bank will have to raise interest rates in order to control inflation.
This is good for carry trade because a higher interest rate means a bigger interest rate differential.
On the other hand, if a country's economic prospects aren't looking too good, then nobody will be prepared to take on the currency if they think the central bank will have to lower interest rates to help their economy.
To put it simply, carry trades work best when investors have low risk aversion. 
Carry trades do not work well when risk aversion is high (i.e. selling higher-yielding currencies and buying back lower-yielding currencies). When risk aversion is high, investors are less likely to take risky ventures.
Let's put this into perspective.
Let's say economic conditions are tough, and the country is currently undergoing a recession. What do you think your next door neighbor would do with his money?
Your neighbor would probably choose a low-paying yet safe investment than put it somewhere else. It doesn't matter if the return is low as long as the investment is a "sure thing."
This makes sense because this allows your neighbor to have a fall back plan in the event that things go bad, e.g. he loses his job. In forex jargon, your neighbor is said to have a high level of risk aversion.
The psychology of big investors isn't that much different from your next door neighbor. When economic conditions are uncertain, investors tend to put their investments in safe haven currencies that offer low interest rates like the U.S. dollar and the Japanese yen.
If you want a specific example, check out Forex Gump's Piponomics article on how risk aversion led to the unwinding of carry trade.
This is the polar opposite of carry trade. This inflow of capital towards safe assets causes currencies with low interest to appreciate against those with high interest.

Carry Trade Criteria and Risk

Carry Trade Criteria

It's pretty simple to find a suitable pair to do a carry trade. Look for two things:

1. Find a high interest differential.
2. Find a pair that has been stable or in an uptrend in favor of the higher-yielding currency. This gives you the ability to stay in the trade AS LONG AS POSSIBLE and profit off the interest rate differential.

Pretty simple, huh? Let's take a real life example of the carry trade in action:

This is a weekly chart of AUD/JPY. Up until recently, the Bank of Japan has maintained a "Zero Interest Rate Policy" (as of September 2010, the interest rate stands at 0.10%).
With the Reserve Bank of Australia touting one of the higher interest rates among the major currencies (currently at 4.50% as of this writing), many traders have flocked to this pair (one of the factors creating a nice little uptrend in the pair).
From the start of 2009 to early 2010, this pair moved from a price of 55.50 to 88.00 - that's 3,250 pips!
If you couple that with interest payments from the interest rate differential of the two currencies, this pair has been a nice long term play for many investors and traders able to weather the volatile up and down movements of the currency market.
Of course, economic and political factors are changing the world daily. Interest rates and interest rate differentials between currencies may change as well, bringing popular carry trades (such as the yen carry trade) out of favor with investors.

Carry Trade Risk

Because you are a very smart trader, you already know what the first question you should ask before entering a trade is right?
"What is my risk?"
Correct! Before entering a trade you must ALWAYS assess your max risk and whether or not it is acceptable according to your risk management rules.
In the example at the start of the lesson with Joe the Newbie Forex Trader, his maximum risk would have been $9000. His position would be automatically closed out once his losses hit $9000.
Eh?
That doesn't sound very good, does it?
Remember, this is the worst possible scenario and Joe is a newbie, so he hasn't fully appreciated the value of stop losses.
When doing a carry trade, you can still limit your losses like a regular directional trade.
For instance, if Joe decided that he wanted to limit his risk to $1000, he could set a stop order to close his position at whatever the price level would be for that $1000 loss. He would still keep any interest payments he received while holding onto the position.