August 27, 2013 in Blog
Interest rates are an often forgotten topic when it comes to Forex, but when it comes to Carry Trades, interest rates should come to the forefront of the discussion. Prior to the financial crisis of 2008, the carry trade was extremely popular, as different countries raised or lowered interest rates and tremendous opportunities existed for outsized gains.
At its core the carry trade relies on central banks to raise or maintain the rates of one country, while another country lowers its rates. These diverging rates allow you to buy the high interest rate currency, while selling the other. In effect you are going to be paid the high rate, while paying the lower rate, pocketing the difference. Although this barebones explanation makes it seem like an easy way to make money, traders must also be aware of potential changes in the exchange rates themselves, which can change drastically and turn a profitable carry trade into a big time loser.
Although the anticipated profits occur due to the difference in interest rates on certain currencies, one must also take into account a multitude of factors that can impact the trade. Factors such as: exchange rates, Central Bank actions, and economic indicators all play a role in the success or failure of a carry trade. If there is uncertainty relating to the direction of the interest rate spread, or suspicion of a narrowing spread, then the carry trade may turn unprofitable quite suddenly, and must be entered into cautiously, with stop losses and take profits in place should something go wrong. Central bank actions can often be difficult to judge and their decisions have blindsided investors in the past, so one must stay up to date on the mindset of these agencies relating to interest rates specifically. Economic indicators are a useful tool in estimating the direction of rates in a particular economy, but all data must be taken with a grain of salt. In general, it is not as simple as just finding a currency pair with a wide interest rate spread; many other factors must be considered and monitored.
Historically, there have been many famous examples of great carry trade success stories, as well as a fair share of failures. From 2003-2004 one of the most popular trades was AUD/USD offering a positive spread of around 2.5%( with leverage 10X equivalent to 25%). This 2.5% was also boosted by a 42% appreciation in the currency pair made this a perfect example of capital appreciation contributing to the anticipated yield gains. On the other end of the spectrum lie the AUD/JPY and NZD/JPY pairs circa 2008. As a result of the Subprime financial crisis, a sell off caused an approximately 45% price drop, making any carry trade profits irrelevant in the face of such tremendous capital losses.
Overall, the theory behind carry trade execution is quite straight forward, but there are many factors to consider and constant monitoring that must take place in order to ensure a profit. Particular attention must be paid to the downside, in the form of exchange rate risk. If your pair is losing value, then your profit from the carry trade becomes negligible or non-existent.
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