What is Currency Carry Trading

Currency carry trades are a way to capitalize on the difference between interest rates in different countries, and spot Forex (and their CFD equivalents) is an excellent market to execute these types of trades.

Let’s learn how to make currency carry trades work in our favour.

What is a Currency Carry Trade? 

A carry trade involves going long of one currency to collect its interest rate and shorting another currency with a lower interest rate that the trader must pay, resulting in the trader collecting the difference between the two interest rates from the broker.

Mechanically, a currency carry trade is opened like any other Forex trade—a long or short position on a Forex pair, except the decision relies on the interest rates.

In case this us confusing, let’s break it down.

The Basics of a Currency Carry Trade 

1. Each currency in a Forex pair has a different overnight interbank interest rate (based on the country’s central bank interest rate). And because Forex transactions are always in pairs, there will usually be two different interest rates.
2. The trader will earn interest on the long currency trade minus paying interest on the short currency. The difference may be positive or negative depending on the interest rate for each currency. For example, if I am long USD/JPY, I earn the interest for the long U.S. Dollar portion and pay interest on the Japanese Yen portion. If the U.S. Federal Reserve interest rate is higher than the Bank of Japan interest rate, I should earn net interest rather than paying interest to the broker for holding the trade. Therefore, a currency carry trade aims to profit from a net positive interest payment for holding the trade open.
3. Brokers will only calculate the interest paid or received on trades open “overnight.” Most brokers consider trades open at 5 p.m. ET to be overnight trades for that day.
4. Brokers calculate the interest on the unleveraged notional value of the trade. Higher leverage works in our favour if the interest rate difference is positive.
5. Brokers refer to the daily interest rate difference paid or received on Forex trades as “rollover fees.”
6. Brokers calculate rollover fees daily and include weekends and holidays. Most brokers apply the weekend rates on a Wednesday as a “triple rollover.” They use the Wednesday before the weekend because most instruments need two business days to settle. Brokers also calculate holiday rollover fees in advance.
7. Brokers usually publish their rollover fees on their site or within their trading platform(s). These can change every day as interbank rates change.
8. Because the currency carry trade is an open Forex position, the position can still have a capital gain or loss depending on how the price of the Forex pair moves.

Currency Carry Trade Example 

In this example, I will look at two currencies with very different interest rates:

• U.S. Dollar interest rate: 5.0%.
• Japanese Yen interest rate: 0.5%

To profit from the difference between these two interest rates, I want to collect the 5.0% interest rate on the U.S. Dollar and pay less interest on the currency that I short against it. In this case, I will only pay 0.5% for being short JPY. Therefore, I want to be long USD/JPY.

Here’s the formula we’ll use (IR means “Interest Rate):

Daily Interest = (IR for the long currency – IR for the short currency)/365 x Notional Value

In our example, we will open one standard lot of USD/JPY, i.e., 100,000 units of U.S. Dollars, and this is the Notional Value of the trade.

The percentages must be in decimals, i.e., 5.0% = 0.05 and 0.5% = 0.005.

Plugging the numbers into the formula gives:

Daily Interest = (0.05 – 0.005)/365 x 100,000 = $12.

Pros and Cons Currency of Carry Trading 

Pros

1. All trades held past 5 p.m. ET have an element of a currency carry trade because of the automatic rollover calculation. For many traders, this is a background element and not the primary reason to enter a trade, with some traders unaware of the positive or negative consequences. However, a currency carry trade specifically aims to profit from the rollover rather than it being a secondary issue.
2. Interest rates are a major fundamental attribute of a currency’s value. Suppose a trader strongly believes that a currency’s interest rate will remain elevated or rise further relative to another currency. In that case, the carry trade is an easy way to capitalize on it.
3. Taking a position for a positive rollover fee does not have to be the only reason to enter the trade but can form part of the decision. For example, if USD/JPY has a positive rollover, I could only take long USD/JPY trades when I think the pair is ready to rise in value. And I can avoid short USD/JPY trades, even if I think the currency will fall because I know the rollover will work against me. The smartest way to take advantage of rollover is to use it as part of a strategy in my favour and not make it the only reason I enter a trade. So, if I am bullish on a Forex pair for other reasons, a positive rollover can help me when I am in the trade.
4. Rollover rates are usually easy to locate for each broker on their site, and brokers usually express it as a value of pips each day, making the calculation easy.      

Cons

1. The biggest issue with currency carry trades is the risk of capital loss. I may open a Forex pair to collect the rollover, but the price of the Forex pair may still go in the other direction, giving me a net loss. (E.g., I may go long USD/JPY for the rollover, but the price of USD/JPY declines by more than the amount of the rollover I collect.) The rollover forms only a small part of the value of the trade.
2. Central bank interest rates can move against the position, reducing the rollover size or even making it negative.
3. Interbank rates can fluctuate even when central bank interest rates do not move, adding a layer of risk to the trade.
4. There are times in the economy when there are few rollover opportunities because interest rate differences are not high. Or the only opportunities are found in emerging market currencies, which are highly volatile and can have high spreads and trading costs.

Risk Management in Carry Trading 

There’s no way to avoid risk in a carry trade completely, but there are ways to manage it. Here are some:

1. Always have a stop loss. This is the most basic piece of advice for any trading, and it applies equally to currency carry trading.
2. Choose Forex pairs that are likely to move in the direction of your position or at least stay within a certain range that you can withstand while collecting the rollover.
3. Avoid Forex positions with high negative rollovers. For example, I may choose not to go short a Forex pair even if I expect it to decline because the short position has a negative rollover that will work against me.
4. Don’t be tempted by high rollovers in Forex pairs containing unstable or volatile currencies, because the risk of capital loss will often be higher than the rollover.

Bottom Line 

Currency carry trading allows traders to profit from the interest rate differences between different currencies. There will be periods of economic conditions where carry trades are popular because of the interest rate environment.

This was true in the early 1990s when the U.S. Federal Reserve dropped interest rates in response to a recession, and from 2004 to 2008 when the Bank of Japan dropped their rates. Currency carry trading is not without risk, the biggest risk being a capital loss if the price of the Forex pair goes against the trader. Always manage risk with an exit plan or stop-loss.

FAQs 

What is the best currency for carry trades?

Any currency with historically high or low interest rates can form the basis of a carry trade. Emerging market currencies can often display this behaviour but also carry higher volatility risk.

Is currency carry trading profitable?

Currency carry trading can be profitable if the price of the Forex pair does not go against the value of the rollover.

Why might a carry trade end badly?

A carry trade might end badly if the position goes against the trader by more than it pays in interest or rollover payments.

What is the difference between a carry trade and arbitrage?

Arbitrage is a risk-free trade. A currency carry trade still has the risk of a capital loss because it means opening an unhedged Forex position.