The investment strategy known as a carry trade is most frequently used in conjunction with foreign exchange trading. In this trade, an investor borrows money at a low interest rate in one currency and invests it in another with a higher interest rate, earning a return that is approximately equal to the difference between the two rates. We examine the strategy’s operation and the reasons behind its widespread use in a variety of investment funds, such as global macro funds and other alternative strategies.
In essence, a carry trade is the profit an investor makes from holding—or carrying—an asset, like a commodity or currency, for a while. It is independent of asset appreciation, though it may influence the trade’s risk.
An investor will borrow money in a currency with a low interest rate in order to purchase an asset or currency with a higher interest rate in a carry trade. One of the most popular approaches for trading foreign exchange is the carry trade. However, it’s a high-risk strategy that needs favorable market circumstances and investment know-how to be implemented.
What are common carry trade?
Because of their wide interest-rate spreads, trading the Australian dollar and Japanese yen or the New Zealand dollar and Japanese yen is a common foreign exchange carry strategy. When purchasing Australian or New Zealand dollars at current rates, an investor can effectively pay 0% interest on a loan made in Japanese yen while earning 2.85% and 3.50%, respectively, after deducting applicable costs and trading fees. The trade’s profit is what makes the final difference.
Borrowing in Japanese yen to invest in Australian or New Zealand dollars is a common carry trade
Central bank rates, 1/1/22–11/14/22 (%)
What are some of the risks?
Interest rate fluctuations and volatile currencies are the main risks associated with trading. For instance, although emerging markets have higher interest rates, there are significant political and national security risks that can result in abrupt currency volatility or depreciation, which could result in significant losses in carry trading. Not only are currencies in emerging markets more erratic, but they can also be more erratic than in developed markets, which could lead to higher daily losses. One of the most erratic emerging-market currencies in recent years has been the Turkish lira: The lira dropped by 27.10% in less than a month, from trading at -2.71% to -45.92% to the U.S. dollar over the course of the 12 months from November 16, 2021, to November 15, 2022. The two main risks associated with currency carry trades are interest-rate risk and fluctuations in currency exchange rates.
Which investment strategies use carry trading?
Because carryy trading can be a high-risk strategy, it needs to be managed carefully to reduce the possibility of suffering significant losses. Carry trading is a component of alternative investment strategies, such as global macro funds and other hedge funds, and it can be combined with positions that can also profit from the momentum in exchange rate fluctuations. Carry trades are also used in a variety of other investment strategies outside alternative investments. Managers conduct in-depth investigation and fundamental analysis in order to formulate opinions regarding central bank policy and macroeconomic factors that are both national and international. Selecting a knowledgeable investment manager is crucial, particularly when thinking about intricate investment plans. Carry trading is a trading style that is utilized in commodities, fixed-income, and equity markets in addition to the currency markets.
How to trade using the Carry Trade?
- Choose the forex market with positive carry you’d like to trade
- Open an account to get started, or practice on a demo account
- Choose your forex trading platform
- Open, monitor, and close positions
An account with a forex provider such as IG is necessary in order to trade the carry trade in the forex markets. A lot of traders keep an eye out for carry trade opportunities in popular forex pairs like EUR/USD, GBP/USD, or USD/JPY. Using tools like IG’s Trading Academy, you can aid in the development of your forex trading strategies.
You can open an account and begin trading forex by following the above steps once your strategy has been developed.
Your entire position size determines your profit or loss. Using leverage will increase your gains and losses. Since losses can exceed your deposit, it’s critical to carefully manage your risks. Before you begin trading leveraged products, make sure you are aware of the risks and rewards involved. Use money you can afford to lose when you trade.
