An Introduction to Carry Trading

The first and main step in entering a carry trade is to determine which currency offers a high yield and which offers a lower one. A currency carry trade is a strategy in which traders borrow in a low-interest-rate currency and invest the proceeds in a high-interest-rate currency, aiming to profit from the interest rate differential. Carry trades tend to perform well in low-volatility environments. Many carry traders are perfectly happy if the currency doesn’t move one penny. The big hedge funds that have a lot of money at stake are perfectly happy if the currency doesn’t move because they’ll still earn the leveraged yield. The yen carry trade has been supported by a seemingly endless supply of ZIRP-enabled currency to borrow and Japan’s commitment to keeping the currency from rising in order to maintain its export economy.

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A carry trade is an investment strategy where an investor borrows money in a currency with a low interest rate and invests in another currency that offers a higher interest rate. The investor does so with the aim of profiting from the interest-rate differential between the two currencies. The phrase “carry trade unwind” is the stuff of a carry trader’s nightmares. A carry trade unwind is a global capitulation out of a carry trade that causes the “funding currency” to strengthen aggressively.

What is a Currency Carry Trade?

Researchers have various surmises for why this is the case—stability and safety tipping the market toward risk aversion being chief among them—but the point is that it’s there. This means that capital tends to flow toward higher-yielding markets, assuming relative economic stability. The policy change came amid a rapid rise in the yen’s value relative to the dollar, a trend that has accelerated in fxcm broker recent sessions. Since July 10, the day before a soft U.S. inflation report set Wall Street’s sights on interest rate cuts, the value of $1 has declined from ¥161.7 to ¥144.18, its lowest since early January. 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. Technically, all positions are closed at the end of the day in the spot forex market.

Borrowing cheaply to buy high-yielding assets is popular, but risky

• Trading in the yen picked up in October 2012 when Abe took office.
• Remember, after a carry trader borrows yen, they sell that yen to buy dollars, pounds, or other currency, depending on where they plan to invest.
• The yen reacted almost immediately to the rate hike, rising to about 150 to the U.S. dollar from about 162 to the dollar earlier in July.
• Managers undertake extensive research and fundamental analysis, formulating views on central bank policy and country-specific and global macroeconomic drivers.

Instead, they perform their strategy using futures or forward currency markets, where they can borrow (use leverage) to boost their potential returns. When traders look for interest rate differences between countries, these should be reflected in the forward exchange rates because of interest rate parity, a fundamental concept in international finance. The funding currency is the currency exchanged in a carry trade transaction, typically characterized by a low interest rate. Investors borrow the funding currency and go short, while taking long positions in the asset currency, which has a higher interest rate. The central banks of funding currency countries such as the Bank of Japan (BOJ) and the U.S. Federal Reserve often engage in aggressive monetary stimulus to prop up economic growth, resulting in low interest rates.

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Yes, there is more than one carry trade, and understanding the distinctions is key to getting a sense of possible vulnerabilities here. But the scale of the declines was exaggerated by the rush to sell U.S. dollars due to carry trade deals that had helped drive markets to record levels. 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). Now consider that adx indicator formula the Bank of Japan has signaled that more rate hikes are possible.

This highlights the often overlooked yet powerful influence of these financial maneuvers on global financial markets. “The carry trade unwind, at least within the speculative investing community, is somewhere between 50%-60% complete,” Arindam Sandilya, co-head of global FX strategy at JPMorgan Chase, told Bloomberg TV on Tuesday. There are legitimate concerns about the U.S. economy, after several leading indicators last week suggested that its growth has slowed. But the $4 trillion unwinding is certainly having a major effect. It probably already triggered more selling by investors who weren’t involved in the carry trade but who saw big names like Nvidia and Tesla selling off sharply.

Carry trading is one of the most simple strategies for currency trading that exists. A carry trade occurs when you buy a high-interest currency against a low-interest currency. For each day that you hold that trade, your broker will pay you the interest difference between the two currencies, as long as you are trading in the interest-positive direction.

Until recently, one of the most popular carry trades involved trading the low-yielding or even negatively yielding Japanese yen against currencies like the Australian dollar or the New Zealand dollar. That’s the chief risk of the carry trade—and any trade that’s backed by borrowed money (i.e., leveraged or “on margin”). When Japan’s interest rates (and currency) shot up at the same time markets were crashing, many carry traders found their positions underwater. They needed to sell any asset they could to raise cash for the dreaded margin calls.

It’s also why, in late July and early August 2024, global investors got a quick lesson in the carry trade and what happens when carry traders are forced to liquidate positions. It all started with a small rate hike by the BoJ (from a range below 0.1% to roughly 0.25%) and a promise by the central bank that there would be more hikes to come. The yen shot up nearly 10% versus the dollar and other major currencies. At one point on August 5, Japan’s benchmark Nikkei 225 was down about 20% from the previous day (see figure 1). The mini-panic spilled over into the U.S. and sent stocks to their worst single-day move since the early days of the COVID-19 pandemic in 2020. In general, a carry trade is any strategy where an investor borrows capital at a lower interest rate to invest in assets with potentially higher returns.

In 2013, Abe raised consumption taxes to lower the nation’s debt. The U.S. dollar rate weakened in 2017 due to uncertainty over President Trump’s economic policies. dowmarkets broker video reviews It strengthened in the latter part of the year, reviving the yen to U.S. dollar carry trade. But the Bank of Japan struggles to keep the yen’s value low, despite QE and low-interest rates. Forex traders purchase the yen as a hedge whenever the dollar declines.

The amount won’t be exactly $12 because banks use an overnight interest rate that fluctuates daily. The interest rates for most of the world’s liquid currencies are updated regularly on sites like FXSTREET. You can mix and match the currencies with the highest and lowest yields. Japan’s Nikkei 225 index plummeted 12% Aug. 5, 2024, marking its second-largest percentage decline on record. The S&P 500 also had significant losses, falling 3% the same day. Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018.

They could also use their newly acquired U.S. dollars to fund investments with a higher expected return. For example, if the pound (GBP) has a 5% interest rate and the U.S. dollar (USD) has a 2% interest rate, and you buy or go long on the GBP/USD, you are making a carry trade. 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 3%. Forex traders can stay on top of them by visiting the websites of their respective central banks. The carry trade is one of the most popular trading strategies in the currency market.