By Miss Rebekah Manning
The carry trade is one of
the most popular strategies
in forex trading because it
guarantees some type return
on medium or long term
positions. Unlike most
strategies for the forex
market, carry trading does
not seek to capture a profit
by exploiting changes in the
value of a currency pair,
but instead focuses on the
interest rate differentials
in currency pairs. The ideal
carry trade is one where the
currency pair experiences
little change in value but
has a wide interest rate
differential.
What to Look For in
a Carry Trade
1.Large interest
rate differentials:
For example, the British
Pound has a 4.50% interest
rate and the Japanese Yen
has a 0.50% interest rate.
That is an interest rate
differential of 4%. This
means if you borrow Japanese
Yen at 0.50% interest rate
and invest it in the British
Pound at a 4.50% interest
rate, you will make 4% in
interest on those borrowed
funds.
2.Healthy Economy of
the Higher Interest Rate
Currency
In general, a country with a
high interest rate should
attract more foreign capital
as investors seek the
highest returns on their
investments. The health of
the economy should also be
taken into consideration.
For England, inflation above
normal at 3% indicates
interest rates may rise in
the near future, which is
typically good for the
British Pound. High
inflation isn’t always good,
especially in the case of
Zimbabwe. The interest rate
in Zimbabwe as of October
2008 is 8500.00%. A carry
traders deam? Absolutely
not, with inflation topping
231,150,888.87% year over
year in October, investing
in this currency would be a
very risky move
Popular Carry Trade
Set-Ups
Because Japanese interest
rates have been so low in
the recent past, a
disproportionate number of
carry trades in the forex
market have involved the
yen. So, let's use the
GBP/JPY for a basic example.
Let's say you know for a
fact that the yen and the
British Pound are going to
maintain a parity over the
coming year with 0.5%
interest for the JPY and
4.5% interest for the
British Pound. Taking
$10,000 and leveraging it
10:1 to buy100,000 units
GBP/JPY you will earn
roughly with 11GBP per day
on that investment, or
4000GBP per year. With the
GBP/USD at an average price
of 1.75, you would make
roughly $7000 on your
investment of $70,000
without a single pip move in
your favor. In an ideal
situation, like the chart
below, investor capital will
also flow in the direction
of the higher yielding
currency and the trader will
profit on that as well, but
that is not the main goal of
the carry trade.
Carry Trade Dangers
Of course, the main danger
with carry trading is the
same with other types of
longer-term forex strategies
– the currency you are
holding might depreciate
against your home currency
as is occurring in the chart
below. If you suspect that
this is going to happen, it
is time for you to get out.
Many carry traders will set
their stops on long term
carry trades at their trades
entry point. This locks in
carry profits and stops the
trade before it takes
position losses. Keep in
mind that carry trading is a
long term strategy and
should be treated as such,
so don’t stress out on
intraday profits and losses.
