The Carry Trade
If you’ve ever placed a forex trade, you might notice your P/L (profit & loss) for that trade shift slightly overnight after the markets have closed. This is what’s known as the carry trade, a payment paid out to or taken from the investor depending on the currency that he has sold and bought. The concept behind the carry trade is fairly simple -> as an investor, we’re looking to borrow money or sell a currency with a low interest rate and purchase the currency with the high interest rate. The result will be a daily payment added to our trade equivalent to the net interest differential between the two countries.
Institutional traders have been taking advantage of the carry trade for a while and their ability to move vast sums of money between countries is the main driver for this. With net central bank interest rates fairly low amongst the major currency pairs (the highest at the time of writing is 1.000%, the USD/CHF), you need to put down a large sum of money for this to be an effective strategy.
The use of leverage, however, has encouraged retail traders to also take advantage of the carry trade. With leverage opportunities of up to 1:500 (where you can place a trade 500x your notional value without requiring that much money), retail traders can place trades of a few thousand dollars without much difficulty.
Calculations and Resources
To calculate the daily return from the carry trade, you can use the calculation below. For this, you need 3 values -> the interest rates of the currency you’re buying from and selling to and the notional amount you are placing on the trade.
So if you were putting $100,000 on the USDCHF (N.B. you want to sell the currency with the lower interest rate and buy the currency with the higher interest rate, so we would be going short USDCHF), your daily interest would equal 0.01/365 * 100000 = $2.74 per day.
To find the most recent interest rate figures, check out FXStreet.
There are two main limitations to the carry trade. The first is that the market still has to go in the expected direction, otherwise you can stand to lose money. For example, let say you went short the USDCHF and the net interest rate stayed solid at 1.000% for an entire year, which is the period of time you hold the trade for. Also during that year, the price of the USDCHF rises by 1.250%. That yields you a net loss of 0.250%. You need the USDCHF to either rise or fall by less than 1.000% in order to make a profit. What this also means is that timing and research is still important and you can’t just put money on a carry trade hoping it will spin you a profit. The interest rate payments are a bonus to your P/L, but if the market outlook is gloomy, you could be in the red quickly.
Another limitation to the carry trade occurs in the possibility of a change in interest rates. It’s worth keeping an eye on when interest rate announcements are due to be made, because if a country changes its rates that lower your net differential, this is the new figure that brokers will use to top up your trade. Interest rates are a highly watched topic in the forex markets and investors will typically have an idea of where they think the announcement is headed, so some pre-announcement buzz in the market might give you an indication of what’s expected to come.