The Carry Trade – What Exactly Is It?

You probably know that each different county sustains different monetary policies depending on their respective economies’ best interests, inflation perspectives, economic cycle, etc. I don’t want to get down into a full blown out course about macroeconomics here, so let’s just state that different countries carry different interest rates.

Well, Forex is nothing but the currency exchange market where people exchange some currencies for another at a set price (market price). Alright, so far so good. But like I just said one currency might yield a different interest rate than another one, so there is a differential that’s got to be paid (or charged) depending on which side of the coin you’re positioned. That interest rate differential translates to us Forex traders as what’s called “swap” in the Forex world lingo, and it’s cashed in (or deducted from) your account on daily basis by your broker.

The interest rates

The interest rates imposed by the world’s main central banks are, as of today, as follows:

USA: 5.25%
Europe: 4.00%
England: 5.50%
Japan: 0.50%
Switzerland: 2.50%
Australia: 6.25%
New Zealand: 8.00%

As you can see, the Yen yields only a 0.50% of interest, whereas the Sterling Pound gives out a quite beefier 5.50%.

But wait a second Hector… I think I might be into something here… what if I asked for a loan in Japan (paying a 0.50% interest rates) and invested it in England (netting a 5.50%)… couldn’t I make some free money? If I went long on GBP and short on JPY simultaneously… wouldn’t I be paid a 5.00% interest rate differential for my money? and what’s more… what if I leveraged myself to 1:100, 1:200 or even 1:400?

And that, my friend, is the core principle of Carry Trading: exploiting the interest differentials between the different currencies in order to pocket the swap. For example, some brokers give 25 US dollars/day per each lot of LONG GBPJPY that you hold overnight (if you’re short, you pay the swap to your broker!). LONG USDJPY is about 11 dollars/day per lot depending on the broker.

The results of Carry Trading

Pull a zoomed-out daily chart of USDJPY, GBPJPY, EURJPY, AUDJPY, CADJPY or NZDJPY. Do you see those massive uptrends all across the board? (again, please remember that this article was writen in June 2007) yup, they all have been rocketing up like there’s no tomorrow. Carry Trading has been *the* trading theme throughout the last year – everyone, their mothers and their flatmates have been shorting the Yen against all the other major currencies seeking for that juicy yield.

How long will it last? who knows, but as long as EUR, GBP, USD, AUD and NZD keep raising their rates (which they’ve been continuously been adjusted to the upside by their respective Central Banks during the last two years already) and Japan stubbornly sustains its almost-zero-percent interest rates policy, I don’t see why the overall upward market sentiment should change any time soon, at least from a fundamental macro-scope point of view.

How to implement the Carry Trading principles into actual trading?

Well, there are many swap-exploiting techniques flying around. I mean, you cannot just go long GBPJPY, NZDJPY or USDJPY out of the blue because you may eat up enormous drawdowns if you miss-time your entry. At the end of the day, even though the overall long term trend is up, we could easily see a period of market re-adjustment and price could fall hundred pips to the downside. Have a look at what happened to GBPJPY in late february / early march 2007 – it plummeted almost 2000 pips within few days! That would most likely annihilate any trading account.

So, what then?

Well, like I say there are many techniques out there. For example, some people open two twin trading accounts: one swap-enabled (under which they long the GBPJPY) and one swap-disabled (under which they short the GBPJPY). Basically they eliminate the currency pair fluctuation by taking opposite trades in different accounts and they slowly-but-steadily bank the swap on one of them.

Other technique is the so-called Carry Hedge Baskets , which basically advocates to open multiple trades on different currency pairs trying to annul each other’s volatility, and thus benefiting exclusively from the swap. For example: Go long GBPJPY (you are paid a very high daily swap) and go short CHFJPY (you pay a very small daily swap). By doing so, in one hand you short the Yen (long GBPJPY) and in the other hand you long it (short CHFJPY), effectively limiting the JPY-fluctuation’s impact on your basket. Then you just need to adjust the lot size according to different money-management factors such as pip-value, the average daily volatility for each pair, etc and voila! you have your own Carry Hedge Basket. These type of baskets are all about money-management engineering, and how ingeniously you hedge the different currency pair in order to cancel each other out as much as possible – remember that the point of these baskets is to keep the volatility to a minimum while profiting from the constant money flow coming from the positive daily swap. I have seen some wicked baskets juggling 10+ currency crosses in and out as needed!