carry trade

What is a Carry Trade?

deltafx writer 19 October 2021

Carry Trade is one of the most well-known investment methods in the financial markets. It involves borrowing or selling a low-interest rate asset to use that money for buying another high-interest rate asset. You can also make some profit from different interest rates by paying a low interest for one asset and receiving a high interest for another one.  

How does a carry trade work?

Trading currencies with the carry trade method has a similar concept. You can borrow one currency and use it to buy another one. The first currency that you borrow or sell must have a low interest rate, and the second one that you buy to collect the interest must have a higher interest rate compared to the first one. The difference between these two interest rates helps you make a profit. Carry trading offers traders a substitution to buy low and sell high, which does not usually happen on a daily basis. Some currency pairs such as NZD/JPY and AUD/JPY are very popular among traders who use carry trading strategies. Such currency pairs involve high-interest rate spreads.

Advantages and disadvantages of a carry trade

As long as currency values are stable, you can make a good profit using carry trade. Stability helps traders to receive a steady return from the high-yield currency. Also, if the high-interest rate currency’s value increases and you pay the loan of low-interest currency with the stronger currency, your profit will be even more.

You can also use leverages for carry trading. The interest you receive from a carry trade is calculated based on the leveraged amount. Therefore, you can make a huge profit by doing flawless carry trades using leverages. However, the carry trading risk is high because you can not be certain about exchange rates. The leverages that you use in carry trading may be your worst enemy, and the slightest changes in exchange rates may result in huge losses. That is why carry trading is only suitable for risk-taking traders. We recommend not to use carry trading as the main strategy of your trading activities.

Carry trading risks

Although carry trading is very lucrative, it involves a lot of risks. To make a good profit, you need to use pretty volatile currencies. In addition, market sentiment can have a significant effect on currency pairs. The traders who do not use risk management strategies may face sudden and large losses. So, it is crucial to use different types of analyses, especially the fundamental analysis, before entering carry trades. A good time to enter these trades is when the buyers are more than the sellers in the market.

The most important risk is the uncertainty of exchange rates, and they can change anytime due to the volatility of some currencies. The second most important risk is related to changes in interest rates which we explain in the following example.

Also Read: How to Create a Trading Plan?

A practical example of a carry trade

For example, you’re a trader, and you figure that the Japanese Yen interest rate is 1%, but the Australian dollar interest rate is 5%. So, you can use the difference between these currencies, which is 4%. Then you should borrow the Japanese Yen and convert it into the Australian dollar. After that, you can invest the Australian dollars into the securities with a 5% interest rate.

To get good results, you wait for a while for your investment. Then you reconvert your Australian dollars and your profits into Japanese Yen, which will be a higher amount than the initial amount. The next step is to return the Japanese Yen that you had borrowed in the beginning. The remaining amount will be your profit. It is a low-risk way to make money using different interest rates. Meanwhile, if the Australian dollar interest rate goes higher than 5%, you can make more money. However, if the Japanese Yen interest rate goes higher than 1%, your profits will be less, and even if it goes beyond 5%, you will lose money. Therefore, the more the interest rate spread, the more profit you will gain.

Conclusion

Carry trading can be very lucrative if you manage everything correctly. It can provide traders with a continuous flow of income if they use good strategies and plans. You should be aware of the risks in the market and always try to manage them to avoid losing money. It is not one of those complex strategies in the forex market, and almost everyone can do it. Fundamental analysis can help you a lot in this process to make successful trades.

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