Learn Forex: What Is a Carry Trade?

1. Learn Forex: What Is a Carry Trade? Learn Forex: What Is a Carry Trade? The carry trade rose to popularity in the mid-1990s, thanks to diverging interest rates between Japan and the U.S. Since then, carry trades have garnered a lot of interest by traders of all types. But what exactly is this type of trade? In the simplest terms, the carry trade involves a trader borrowing currency from a country with a low interest rate. In the mid-1990s, that was Japan. The investor then converts it to a currency from a country with higher interest rates. The trader then invests the currency at that higher interest rate, creating a “positive carry” for the trader caused by the interest rate differential. For traders, the carry trade can benefit them in a few ways. First, the difference in interest rate creates profits, regardless of the exchange rate moving. The exchange rate can stay the same, but thanks to the interest rate differential, the investor will still earn money. But secondly, if the currency that’s been shorted decreases in value compared to the invested currency, the trader’s profits increase even more. It’s an added benefit. Traditionally, carry trades have been carried out by large financial institutions, because to turn a true profit, these trades have to be carried out on a very large scale. For example, if Country A’s interest rate is .5% and Country B’s interest rate is 5.5% -- the investment would yield 5% over the course of a year. So on a $1 million USD the profit would be $50,000 on interest, even if the exchange rates didn’t move. With added leverage, say 100:1, this carry trade would return a cool $5 million in profit.

2. Carry Trade Example Carry Trade Example Here’s a quick example: Country A and Country B have interest rates of 1% and 5% respectively. Additionally, the exchange rate between these countries is 2-to-1 favoring Country A, meaning 1 of Country A’s currency equals 2 of Country Bs. The trader goes to his broker and asks to borrow 1,000,000 of Country A’s currency. Then she converts it to 2,000,000 of Country B, and invests it for one year. Over the course of the year at 5% interest, the investment would yield 100,000 in Currency B. The investor would then convert this back to currency A – which would be 1,050,000 in Currency A – and pay back the 1% percent in interest it cost to borrow the currency or 10,000 in Currency A. The profit would then be 40,000 of Currency A, and with 25:1 leverage, the investment would yield 1,000,000 in profit. Presented By Learn To Trade