The currency market is a versatile and highly volatile global market where investors and traders always have an opportunity to make money, regardless of who is in control – whether it is the bears or the bulls. Carry trade comes into play in a continuous and strong trend, or in a scenario of rising or falling interest rates. It provides traders with all the required tools to benefit from market movements. Carry trade is a highly popular trading strategy widely used in the currency market, where a trade is kept in a high-yielding currency against a low-yielding currency, or by buying the high-yielding currency and going short on a low-yielding currency.
The Japanese yen is one of the most attractive currencies to trade with the Australian dollar or New Zealand dollar, as the interest rate spread in these currency pairs is much higher. This enables a trader to benefit from carry trades by earning interest along with the movement of the currency pair. To select a profitable carry trade, one must find the high-yielding currency and the lowest interest-yielding currency to form the perfect pair for trading. This selection process not only considers the interest rate factor and yield but also takes into account other fundamental and technical factors to increase profitability and trade accuracy.
Australia (AUD) 4.35%
New Zealand (NZD) 5.50%
Canada (CAD) 4.50%
U.K. (GBP) 5.25%
U.S. (USD) 5.50%
Swiss franc (CHF) 1.50%
Japanese yen (JPY) 0 – 0.1%
A trader needs to consider the prevailing interest rates when engaging in currency trading. This allows the trader to pair the currencies with the highest and lowest interest rate yields and enter into a carry trade. However, it’s crucial to note that interest rates can change at any time, so forex traders should stay updated with the latest developments in interest rates.
Currently, the most popular pairs for the carry trade are AUD/CHF and NZD/CHF, as New Zealand, Australia, and Canada have the highest interest rate yields, while the Swiss Franc has the lowest. In the Forex market, currencies are traded in pairs, providing traders with an ideal environment to benefit from the yield spread between two currency pairs. Additionally, the low borrowing cost of the Japanese yen is an advantage widely utilized by equity and commodity traders globally.
The primary appeal of the carry trade lies in the ability to earn interest by exploiting the spread between two currencies. In a carry trade, interest is earned through triple rollover, which is calculated on Wednesday to account for the carry position over Saturday and Sunday. In simple terms, a trader can earn interest by maintaining an open position that takes advantage of the positive yield spread. Carry trades not only generate income through interest but also capitalize on movements in the currency pair, which can add to the trade’s value.
The main objective of a carry trade is to earn interest by leveraging the interest rate gap between two countries and trading the currency pair that offers the highest yield.
The ideal market environment for successful carry trades is one with low volatility or a range-bound market. In such conditions, the market tends to increase its risk appetite, attracting new traders looking to profit from the market. Carry traders seek high yields, and positive capital appreciation gives them an advantage. Many large institutional investors and hedge funds prefer to trade in low-volatility environments, increasing their exposure during sideways market movements, also known as asset accumulation. In a low-volatility market, carry traders focus on yields rather than profits from market movements. As long as the currency remains stable or increases in value, carry trades remain profitable due to the interest rate earned by holding the position.
Carry trades are a very useful tool to earn interest in both increasing and decreasing interest rate atmosphere. Carry trades work when central banks either increasing interest rates or plan to increase them and vice versa. Money tends to move from low interest giving country to a high interest paying country, and big institutional investors tend to move a huge amount of funds in order to get a higher return on their investment via interest. The carry trade not only attracts traders who are searching for high yield but also the investors who are looking for capital appreciation tends to get attracted by the growth potential of a carry trade.
In an increasing interest rate scenario the central bank increases the interest rates and investors and trades can be seen adding there same carry trades which will in turn pushes the value of the currency of that country higher and make it more valuable the secret to getting the most out of the market in the increasing interest trade scenario is to get in a carry trade in the last stage of rate tightening cycle so that you can enjoy the high tides of interest trade and get out of the market at the starting of the interest rate peak.
In a scenario of falling interest rates, the profitability and reliability of a carry trade come into question when countries that used to offer high interest rates begin to cut or slowly reduce their interest rates. This results in a decrease in the flow of money into the higher interest-giving country, putting pressure on the profits of a carry trade in that currency. The initial shift in interest rates and monetary policy tends to impact the value of a country’s currency, which is reflected in the market movement of that currency.
To earn profits from a carry trade, a trader needs to find a high-yielding and slowly appreciating currency pair. In successful carry trades, the selected currency pair needs to be either low in volatility or in a bullish trend.
However, when interest rates start to fall or the central bank decides to decrease interest rates, foreign investors, institutional investors, and traders tend to shift their funds from that country. They are less compelled to hold onto that country’s currency and instead look for a high-yielding economy offering a higher interest rate elsewhere for more profitable opportunities. This situation leads to a decrease in demand for the relative currency, resulting in a significant sell-off in the currency’s value.
A restrictive policy of a particular central bank can have a negative impact on the carry trade. This happens when the central bank takes actions to prevent a significant increase or decrease in the local currency, leading to the failure of carry trades. For an export-oriented country, an excessively strong currency or a strong bullish trend in the local currency can cause a decline in the profitability of local exports. Conversely, a weak currency can result in reduced margins for foreign companies operating domestically.
Forex is a global market, and there is always a central bank that increases or decreases interest rates. A carry trade is a highly effective tool to benefit from the difference in interest rate yield of different countries by trading the currency pair of those countries. To be a successful carry trader or investor, one should not only look for a currency offering a high yield and another offering the lowest yield, but also pay attention to other currency pairs offering similar positions and trade a basket of currencies. Diversifying trades is a good idea to avoid huge losses due to sudden market movements. By trading a basket of currency including three or more highest and lowest yielding currencies, a trader can create an effective carry trade strategy to make money even in adverse market conditions.
The carry trade portfolio depends on multiple currency pairs, allowing for risk and return diversification. This makes carry trade a long-term investment strategy suitable for investors looking for capital appreciation and interest earnings. It is widely used by investment banks and institutional investors focused on steady returns rather than sudden movements.