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Carry Trade
Among the popular and effective strategies employed by forex traders, the carry trade is perhaps the most profitable and promising one for beginners. Widely employed by institutional and amateur traders, the carry trade is the main driver of movements in Japanese Yen pairs, and it is also an important source of liquidity in the currency market. No forex analysis can be complete without considering the impact of the carry trade, and no forex course will be beneficial without discussing its importance and profit potential.
The carry trade involves the exploitation of interest rate differentials between central banks. Currencies held overnight by a trader generate interest income on the basis of this differential, and over a long period of time with the use of leverage, this income can be significant. To give an example, since the Reserve Bank of Australia usually pays a significantly higher interest rate than the Bank of Japan, a buyer of the AUD/JPY pair (who is buying the Australian dollar and selling the Japanese Yen) will see his account value increase at the end of each trading day by a small amount. If he uses leverage reaching up to 50:1, or 100:1, the accumulation of profits will be fifty or a hundred times faster. Even if a more prudent leverage level is employed, over a period of a couple of months very significant returns are possible.
What drives the carry trade? In fact the carry trade is just another manifestation of the general movement of capital to developed, higher-yielding currencies from lower yielding, developing ones. Although the trader is buying a currency to exploit a higher interest rate, the higher interest rate itself is usually made possible by increased investment activity, and economic dynamism in the host nation’s economy. Larger financial actors, such as banks and hedge funds, and industrial corporations note this dynamism, and pool their capital to such developing nations in search of higher yield, and of course, in order to invest, they must purchase the developing nation’s currency. By participating in the carry trade the trader is siding with these large, powerful actors, and as such, he’s seeking to be one of the winners.
Of course the carry trade is not always reflective of healthy fundamentals. Sometimes speculative activity overtakes economic facts, and a high-yield currency can appreciate beyond its true potential. A more expensive currency dampens exports (goods sold are more expensive), and encourages imports (buying from foreign markets is cheaper), and this process may eventually result in a large trade deficit. The ultimate outcome of such a situation can be a currency crisis, wiping out gains. Since the favored currencies of carry traders usually run deficits, they are very sensitive to adverse news and shocks, and can generate wild and sharp swings which can be very damaging to leveraged accounts.
The currency exchange market is vast and diverse, and there are many opportunities awaiting exploitation by forex traders. The carry trade is one lucrative, relatively safer, and successful strategy, but it is better to implement it as part of a general method, rather than as the only strategy. Diversification is usually a good safety mechanism, and the carry trade is no exception to the rule. |
