Currency Carry Trades Deliver

Whether you invest or trade in the stock, bond, commodities or currency market, it is likely that you have heard of the carry trade. This strategy has generated positive returns since the 1980s, but only in recent years has it received much media attention. For those of you who are still befuddled by what a carry trade is and why the hysteria surrounding the trade has extended beyond the currency market, welcome to Carry Trades 101. We will explore how a carry trade is structured, when it works, when it doesn't and the different ways that short- and long-term investors can apply the strategy.


What is the carry trade?
The carry trade is one of the most popular trading strategies in the currency market. Mechanically, putting on a carry trade involves nothing more than buying a high yielding currency and funding it with a low yielding currency, similar to the adage "buy low, sell high."

The most popular carry trades are currency pairs like the Australian dollar/Japanese yen, New Zealand dollar/Japanese yen and the British pound/Swiss franc because the interest rate spreads of these currencies pairs are very high. The first step in putting together a carry trade is to find out what currency offers a high yield and what one offers a low yield.
As of June 2007, the interest rates for the most liquid currencies in the world were as follows:

New Zealand (NZD)

8.00%

Australia (AUD)

6.25%

U.K. (GBP)

5.50%
U.S. (USD)
5.25%

Canada (CAD)

4.25%
Eurozone (EUR)
4.00%
Swiss franc (CHF)
2.25%
Japanese yen (JPY)
0.50%

With these interest rates in mind, it is simple to see which countries are offering the largest and smallest yields. Traders can keep on top of these interest rate levels by either visiting DailyFX.com or by going to the websites of specific central banks. Given the fact that New Zealand and Australia have the highest yields on our list while Japan has the lowest, it is hardly surprising that AUD/JPY is the poster child of carry trades. Currencies are traded in pairs so all an investor needs to do to put on the trade is to buy NZD/JPY or AUD/JPY on his or her forex trading platform.

The Japanese yen's low selling cost is an attribute that has been capitalized by equity and commodity traders as well. Over the past few years, investors in other markets have started putting on their own versions of the carry trade by shorting the yen and buying U.S. or Chinese stocks, for example. This has fueled a huge speculative bubble in both markets as well as strong correlation between carry trades and stocks.

The Mechanics of Earning Interest
One of the cornerstones of the carry trade strategy is the ability to earn interest. The income is accrued every day for long carry trades with triple rollover given on Wednesday to account for Saturday and Sunday rolls. Roughly speaking, the daily interest is calculated in the following way:
(Interest Rate of the Currency that you are Long – Interest Rate of the Currency that you are Short) x Notional of Your Position
# of Days in a Year


For 1 lot of NZD/JPY that has a notional of 100,000, we compute interest the following way:

(.8 – 0.005) x 100,000 = approximately $20 a day
365

It is important to realize that this amount can only be earned by traders who are long NZD/JPY. For those who are fading the carry, interest will need to be paid every day.

Why has a Strategy this Simple Become so Popular?
Between January 2000 and May 2007, the Australian dollar/Japanese yen currency pair (AUD/JPY) offered an average annual yield of 5.14%. For most people, this return is a pittance, but in a market where leverage is as high as 200:1, even the use of five to 10 times leverage can make that return extremely extravagant. Investors earn this return even if the currency pair fails to move one penny. However, with so many people addicted to carry trades, the currency almost never stays stationary. In the past 6.5 years, the AUD/JPY exchange rate increased 83%, bringing the cash-on-cash return on a long AUD/JPY trade to 100%. At two times leverage, that's 200%.















If It Were Only This Easy
Unfortunately, the carry trade strategy is not just about going long a currency with a high yield and shorting a currency with a low yield. It is not difficult to realize that this strategy fails instantly if the exchange rate devalues by more than the average annual yield. With the use of leverage, losses can be even more significant, which is why when carry trades go wrong, the liquidation can be devastating. Therefore, it is important to understand when carry trades work and when they fail.

When do carry trades work?

Central Bank Increasing Interest Rates: Carry trades work when central banks are either increasing interest rates or plan on increasing them. Money can now be moved from one country to another at the click of a mouse, and big investors are not hesitant to move money from one country to another in search of not only high, but also increasing, yield. The attractiveness of the carry trade is not only in the yield, but also the capital appreciation. When a central bank is raising interest rates, the world notices and there are typically many people piling into the same carry trade, pushing the value of the currency pair higher in the process. The key is to try to get into the beginning of the rate tightening cycle and not the end. (To learn more, read Trying To Predict Interest Rates and Get To Know The Major Central Banks.)

Low Volatility, Risk-Seeking Environment: Carry trades also perform well in low volatility environments because traders are more willing to take on risk. What carry traders are looking for is the yield - any capital appreciation is just a bonus. Therefore, most carry traders, especially the big hedge funds who have a lot of money at stake, are perfectly happy if the currency does not move one penny, because they will still earn the leveraged yield. As long as the currency doesn't fall, carry traders will essentially get paid while they wait. Also, traders and investors are more comfortable with taking on risk in low volatility environments. When they take on risk, it has become a habit to fund these riskier trades with short yen positions.

When do carry trades fail?

Central Bank Reduces Interest Rates: The profitability of carry trades comes into question when the countries who offer high interest rates begin to cut them. The initial shift in monetary policy tends to represent a major shift in trend for the currency. For carry trades to succeed, the currency pair either needs to not change in value or appreciate. When interest rates decrease, foreign investors are less compelled to go long the currency pair and are more likely to look elsewhere for more profitable opportunities. When this happens, demand for the currency pair wanes and it begins to sell off. Depreciation in the currency pair could easily wipe out any interest income.

Central Bank Intervenes in Currency: Carry trades will also fail if a central bank intervenes in the foreign exchange market to either stop its currency from rising or prevent it from falling further. For countries that are export dependent, an excessively strong currency could take a big bite out of exports while an excessively weak currency could lead to significant backlash. This is particularly true for the Japanese yen, the preferred funding currency, because many companies in foreign nations have complained loudly that the weakness in the Yen is making their goods less competitive in the global market. They have asked their own politicians to put pressure on the Japanese to either increase interest rates or intervene in the currency to prevent it from falling even more. Either of these tactics would strengthen the yen, which would bring down the exchange rate of carry trades. The same can be said of intervention by the Reserve Bank of New Zealand to weaken the value of the New Zealand dollar.

Best Way to Trade Carry is Through a Basket
With the pros and cons of carry trading in mind, the best way to trade carry is through a basket. When it comes to carry trades, at any point in time, one central bank may be holding interest rates steady while another may be increasing or decreasing them. With a basket that consists of the three highest and the three lowest yielding currencies, any one currency pair only represents a portion of the whole portfolio; therefore, even if there is carry trade liquidation in one currency pair, the losses are controlled by owning a basket. This is actually the preferred way of trading carry for investment banks and hedge funds. This strategy may be a bit tricky for individuals because trading a basket would naturally require greater capital, but it can be done with smaller lot sizes. The key with a basket is to dynamically change the portfolio allocations based upon the interest rate curve and monetary policies of the central banks.

Benefiting from the Carry Trade
The carry trade is a long-term strategy that is far more suitable for investors than traders because investors will revel in the fact that they will only need to check price quotes a few times a week rather than a few times a day. True carry traders, including the leading banks on Wall Street, will hold their positions for months (if not years) at a time. The cornerstone of the carry trade strategy is to get paid while you wait, so waiting is actually a good thing.

Partly due to the demand for carry trades, trends in the currency market are strong and directional. This is important for short-term traders as well because, in a currency pair where the interest rate differential is very significant, it may be far more profitable to look for opportunities to buy on dips in the direction of the carry than to try to fade it. For those who insist on fading AUD/JPY strength for example, they should be wary of holding short positions for too long because with each passing day, more interest will need to be paid. The best way for shorter term traders to look at interest is that earning it helps to reduce your average price while paying interest increases it. For an intraday trade, the carry will not matter, but for a three-, four- or five-day trade, the direction of carry becomes far more meaningful.

by Kathy Lien

Kathy Lien is Chief Strategist at the world's largest retail forex market maker, Forex Capital Markets in New York. Her book "Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Swings" (2005, Wiley), written for both the novice and expert, has won much acclaim. Easy to read and easy to apply, this book shows traders how to enter the currency market with confidence - and create long-term success! Kathy has taught currency trading seminars across the U.S. and has also written for CBS MarketWatch, Active Trader, Futures Magazine and SFO Magazine. Follow her blog at www.kathylien.com