Forex gives traders the privilege to make profits even when the market isn’t moving. A carry trade includes buying a currency that has a larger interest rate whereas the currency with a lower interest rate would be borrowed or sold. You collect the currency with higher interest trade and paying a lower interest rate on the currency borrowed or sold. The profit is made with the difference between the interest rates.
The strategy is simple and profitable depending on the daily interest payments and availability of leverage. If a position is to hold by you overnight, your broker will automatically credit or debit your account with the overnight interest rate difference. This is called rollover cost in the FX jargon.
In the past, a popular carry trade was buying the AUD and selling the JPY. The central banks cut down their interest rates for spurring the economic growth and the inflation after 2008 economic crisis. The NZD/CHF currency pair gives the largest interest rate differential. The long position on NZD/CHF would collect a 2.50% pa interest. With leverage, the profit will be larger.
When do Carry Trades Work?
When the risk aversion amongst the investors is low, carry trades works the best. They are optimistic and would wish to buy higher-yielding currencies and sell the lower ones. When the aversion of risk is high, investor will invest their money into safe haven into low yielding currencies such as the USD, franc and yen. They will appreciate its value. The capital loss of the process of buying and selling these low yielding currencies in carry trade will put off interest gain.
Market expectations of future interest rates hikes are crucial. So that well performing countries will hike their interest rate to control the inflation. This will impact the carry trade position. when a country doesn’t perform well, their chances are to lower the interest rate to speed up the economic activity.
Criteria and Risk of Carry Trades
To find a carry trade is an easy task. You have to watch for two points: 1. Interest rate differential and 2. Uptrend of the higher yielding currency. The AUD/CHF pair fulfils these criteria. The pair has a 2.25% interest rate differential and the chart below shows the AUD trending up since 2015.