Carry trade strategies
Carry trade strategy is an example of a speculative strategy which consists of taking advantage of the difference in the currency interest rates. This difference is widely known as 'spread'.
The strategy works as follows: an investor borrows the money in the currency of the country with the relatively low interest rate and invests them in the currency of the country with the highest interest rate. The difference (spread) between interest rates can be substantial.
Carry trade forex strategy takes place when you buy a high-yielding currency and sell a lower-yielding currency.
It can generate profit by:
- Earning the interest-rate between the two currencies - the carry
- Spot prices appreciate in the direction of the interest-rate differential
Carry trades is best for low-volatility environments when markets are stable. It is definitely a long-term strategy.
How does the carry-trade strategy work?
The carry trade strategy works best under certain market conditions. In the other words, in order to yield a maximum profit and maintain effectiveness, the stable macroeconomic environment is demanded, both on the financial and foreign exchange markets.
The strategy makes use of the fact that the currencies of the countries with high interest rates have a tendency to strengthen themselves; however, the currency risk must be taken into consideration. This great risk is mostly due to uncertainty of exchange rates. Generally, the transactions are made with a lot of leverage, so even the smallest movement in exchange rates can result in heavy loss unless the transactions are protected appropriately. What is more, the matter of great importance is choosing the right pair of currencies. In order to deal with that, traders focus on two main issues. On the one hand, the crucial thing is the spread, but on the other hand the health of the economy of given pair is taken into consideration, to ensure that the market will change to traders’ favor. This means to buy a currency with a strong economy, and sell a currency with weaker economy.
The most selected currency pairs are namely: GBP/JPY, GBP/CHF, AUD/JPY, EUR/JPY, CAD/JPY, and USD/JPY.
Profits
In theory, the carry trade strategy should not make an expected profit because the difference in the interest rates of the two countries ought to be equated by means of a relatively high exchange rate. Than, the currency of the country, which has low interest rates, is supposed to strengthen itself in relation to the currency of the country with high interest rates. In spite of that, in practice the carry trade brings about weakness of the currency of the country which is its objective. It is a result of converting the currency, which has been borrowed, into currencies of different countries by market participants.
Interest rates
In this case, the traditional income stream of the commercial bank is generated by a following strategy. The first step is to obtain money very cheap, for example buy at the overnight interest rates or at those which are paid by bank to depositors and borrow somebody at long-term credit interest rates, in order to make a profit. The strategy works well in case of an upward-sloping yield curve, but does not if the curve becomes inverted. During the Paul Volcker term, the head of FED, the floating of short-term interest rates caused the same problem and led to savings and loan crisis of the 1980s and 1990s, commonly referred to as the S&L crisis.