Sticking your neck out with currency carry trade

Most currency traders must already be familiar with the concept of currency carry trade. However, it is important to understand the risks involved in this form of trading vis-à-vis the high returns that it seems to promise, especially in the context of the fluid forex markets of today.

Currency carry trade involves borrowing money from nations with low interest rates and investing it in nations that yield higher returns. The most popular nation for the purpose of borrowing cheap traditionally has been Japan, where interest rates have been hovering around 0%

Example of currency carry trade

Trader borrows 10,000 Yen at 0% from a Japanese bank
He converts it into US dollars at the exchange rate of 100 Yen = 1 US dollar
He invests US $ 100 in US bonds yielding 4%
At the end of 1 year he earns $4, without paying any interest for his Japanese borrowing
He converts his $104 into Yen and repays the principal with a profit of $4

This example assumes that exchange rate between the yen and the dollar remained the same

This gain can be enhanced by the use of leverage, which allows trading at multiple levels of margin money. Thus if the trader could have used a common leverage factor of 10:1, he could have multiplied his profit to $40 on his borrowing of $100, which is a whopping 40%. If the leverage level is increased to 100:1, the profitability could shoot up to 400%,

Risks to carry trade

As you might have been able to guess, the greatest risk that a carry trade transaction can face is a change in exchange rates. In the example above, if the Yen were to move up to 96 Yen = 1 US dollar, the trader’s entire profit would be wiped out.

The trader would enter into a dangerous position if the exchange rate were to rise to 94 Yen = 1 US dollar. If the trader had leveraged his borrowing by 100:1, his total outstanding to the bank would be 1000,000 Yen.

Illustration of the loss

Trader borrows 1000,000 Yen at 0% from a Japanese bank at the leverage level of 100:1. His own margin money being 10000 Yen
He converts it into US dollars at the exchange rate of 100 Yen = 1 US dollar
He invests US $ 10,000 in US bonds yielding 4%
At the end of 1 year he earns $400 and his total corpus becomes $10400
However, the exchange rate has moved to 94 Yen = 1 US dollar
On converting his corpus of $10400 into Yens, he finds that he is left with 9,77,600 Yen. His loss equals 22400 Yen.

Smart carry trade strategies

While, carry trade can provide opportunities for huge profits, slight swings in the exchange rates can lead to substantial losses, especially when the leverage levels get very high. Smart strategies for carry trade rely upon the intelligent selection of a currency pair. Thus the carry trader’s main focus should be to select a currency pair where the interest differential is sufficiently high and where the carry trader expects favorable movement of exchange rates.

Carry trade as self perpetuating cycle
Carry trade leads to borrowing in low interest currency and then the sale of that currency to buy another currency to invest in the higher yielding nation. Once the virus of carry trading spreads and a large number of traders get involved in it, the continuous selling pressure on the low yield currency exerts a downward pressure on the currency value. This increases profitability for carry traders and encourages greater exposure to carry trade and more borrowing in the low yield currency and its further sale takes place. This becomes a self perpetuating cycle, where increasing carry trade leads to depreciation of the currency, which further attracts more carry trade opportunities!!

The role of economics in carry trade

The strengths of the economies of the respective currency pairs selected can play a key role in the relative movement of exchange rates for the currency pair. If the trader expects that the economy of currency in which he has borrowed is likely to get weaker, then the central bank of that nation may lower interest rates and the currency may weaken further. Assuming the currency in which the trader has invested stays stable, his profits are likely to go up. On the other hand, if the economy of the nation in which the money has been invested is likely to grow and face inflation, the central bank of the nation is likely to increase interest rates. This may cause the currency to appreciate and increase profitability. Thus, carry traders need to evaluate a variety of economic signals and plan out their trading strategies doubly carefully as the double edged sword of leverage can end up being doubly sharp!!

  • kia4ever

    great post, thanks man

  • kia4ever

    great post, thanks man

  • luckycharm

    Hmm, Very interesting! I’m new to all this, but I am also a physicist and as such I know that there is no “perpetuum mobile”. So what keeps everything from “collapsing” into a carry trade implosion?? (I.e. Why aren’t every carry trader filthy rich?)

  • luckycharm

    Hmm, Very interesting! I’m new to all this, but I am also a physicist and as such I know that there is no “perpetuum mobile”. So what keeps everything from “collapsing” into a carry trade implosion?? (I.e. Why aren’t every carry trader filthy rich?)

  • demontez

    This is a great trade idea.Very fascinating. i guess the risk exposure to this carry trade is the fluctuation of the exchange rate of the currency pair. But i feel that could be reduced through a hedging strategy. Also i feel this carry trade requires you to have access to capital as well.
    But in any case it is a good trade idea. Thanks you.

  • demontez

    This is a great trade idea.Very fascinating. i guess the risk exposure to this carry trade is the fluctuation of the exchange rate of the currency pair. But i feel that could be reduced through a hedging strategy. Also i feel this carry trade requires you to have access to capital as well.
    But in any case it is a good trade idea. Thanks you.

  • coolhand37

    DOWN WITH THE FED!!!
    EVERYONE SHOULD STEP BACK AND TAKE A LOOK AT WHAT THE FED HAS DONE TO OUR COUNTRY! Do not support any type of “World Currency” made from any type of central bank. All of those who posted on this site and all those who favor any type of world bank is asking to empower the banking cartels which are already in place. I would imagine that these people are either raging liberals or neo-conservatives, who do not have you or your freedom in “their” interests. Don’t let these idiots fool you with their puffed-up intellectual nonsense.

    Ask yourself the larger question, who will be printing this money, who will decide the supply and demand of the currency. In what way could some world bank have every countries interest in mind at all times. Currencies like this are tools that the rich use to destroy the middle-class and the poor. Currency give them the power to cause depression and panic whenever they like by controlling interest rates and the supply of money. Step back and look at the Fed, which was put in place to prevent these things from happening. The Fed has only directly caused these problems, the big banks are the only ones who consistently benefit. The smaller banks get ruined just like the poor and middle-class by these vampires.

    Wake up people, watch “The Creature from Jekyll Island”, “The Money-Makers”. Research the price of gold compared to oil over the last 100 years, especially take a good look at the prices since 1970. Ask yourself why 1%of the population has 99% of the wealth. Ask yourself why a family can no longer support themselves on one income and be considered middle-class in post WWII standards.

  • coolhand37

    DOWN WITH THE FED!!!
    EVERYONE SHOULD STEP BACK AND TAKE A LOOK AT WHAT THE FED HAS DONE TO OUR COUNTRY! Do not support any type of “World Currency” made from any type of central bank. All of those who posted on this site and all those who favor any type of world bank is asking to empower the banking cartels which are already in place. I would imagine that these people are either raging liberals or neo-conservatives, who do not have you or your freedom in “their” interests. Don’t let these idiots fool you with their puffed-up intellectual nonsense.

    Ask yourself the larger question, who will be printing this money, who will decide the supply and demand of the currency. In what way could some world bank have every countries interest in mind at all times. Currencies like this are tools that the rich use to destroy the middle-class and the poor. Currency give them the power to cause depression and panic whenever they like by controlling interest rates and the supply of money. Step back and look at the Fed, which was put in place to prevent these things from happening. The Fed has only directly caused these problems, the big banks are the only ones who consistently benefit. The smaller banks get ruined just like the poor and middle-class by these vampires.

    Wake up people, watch “The Creature from Jekyll Island”, “The Money-Makers”. Research the price of gold compared to oil over the last 100 years, especially take a good look at the prices since 1970. Ask yourself why 1%of the population has 99% of the wealth. Ask yourself why a family can no longer support themselves on one income and be considered middle-class in post WWII standards.