FX 101: Understanding carry trades in the forex market

Key points:

• Carry trades are a popular strategy in the FX market, offering the potential for profit through interest rate differentials.
• It involves borrowing money in a currency with a low-interest rate (funding currency) and investing it in a currency with a higher interest rate (target currency).
• Most common funding currencies are JPY and CHF, while most common target currencies are AUD, NZD, BRL, TRY and MXN.
• Low volatility in the FX market can further fuel carry trades by providing a stable and predictable environment, increasing traders' risk appetite, and reducing hedging costs.
• Careful risk management is warranted.

What is a Carry Trade?

Carry trades are a popular strategy in the foreign exchange (Forex) market. It involves borrowing money in a currency with a low-interest rate and investing it in a currency with a higher interest rate. The primary goal is to profit from the interest rate differential, known as the "carry," which can result in positive returns.

How Do Carry Trades Work?

Currency Selection: Traders select two currencies for the trade. The currency they borrow (the "funding currency") typically has a lower interest rate, while the currency they invest in (the "target currency") has a higher interest rate. The idea is to profit from the interest rate differential between these two currencies.

Borrowing Funds: Traders borrow money in the funding currency. They do this by either taking out a loan or utilising a margin account offered by their broker. This borrowed money is often referred to as the "carry trade position" or "carry trade funding."

Investing in the Target Currency: The borrowed funds are then converted into the target currency and invested in assets that provide a return, such as government bonds or other interest-bearing securities denominated in the target currency.

Earning the Carry: As time passes, the trader earns interest on the invested funds in the target currency. This interest, often referred to as the "positive carry," is the difference between the interest rate earned on the target currency investments and the interest rate paid on the borrowed funds in the funding currency.

Let us take an example:

• Suppose a trader borrows 10,000 Japanese yen (JPY) at an interest rate of 0.1%.
• The trader then converts the 10,000 JPY into U.S. dollars (USD) and invests it in an instrument that yields a 4% interest rate.
• The trader earns the difference between the interest paid on the borrowed yen and the interest received from the investment in dollars. In this case, the interest differential is 3.9% (4.0% - 0.1%).

Factors Influencing the Choice of Currency Pairs

Interest Rate Differential: The primary driver of carry trades is the difference in interest rates between two currencies. Traders look for pairs where this differential is substantial.

Market Liquidity: Highly liquid currency pairs are preferred as they allow for easier execution of trades and tighter spreads, reducing transaction costs.

Volatility: Traders often prefer pairs with lower volatility for carry trades to minimize the risk of adverse currency movements that could erode the interest rate gains.

Economic Stability: Currencies from stable economies are generally preferred to reduce the risk associated with economic and political instability.

Policy Outlook: The monetary policy outlook of the respective central banks plays a crucial role. Traders monitor potential interest rate changes that could affect the attractiveness of the carry trade.

How Low Volatility Fuels Carry Trades

Stable Market Conditions: Low volatility in the FX market creates a more stable environment for carry trades. When exchange rates are relatively stable, the risk of adverse currency movements decreases, making it easier for traders to profit from the interest rate differential without the fear of significant losses due to exchange rate fluctuations.

Predictability: Low volatility enhances the predictability of returns from carry trades. When currency prices are stable, traders can more accurately forecast their potential profits and losses, leading to more confident and strategic decision-making.

Risk Appetite: In low-volatility environments, investors' risk appetite tends to increase. As market conditions appear less threatening, traders are more willing to engage in carry trades, leveraging their positions to maximize returns from interest rate differentials.

Cost of Hedging: With lower volatility, the cost of hedging against adverse currency movements decreases. This makes it cheaper for traders to protect their positions, thus encouraging more participation in carry trades.

Common Pairs for Carry Trades

Most Common Funding Currencies

• Japanese Yen (JPY)
• Swiss Franc (CHF)
• Euro (EUR) (especially during periods of very low or negative interest rates)
• U.S. Dollar (USD) (when its interest rates are low compared to other currencies)

Most Common Investing Currencies

• Australian Dollar (AUD)
• New Zealand Dollar (NZD)
• U.S. Dollar (USD) (when used against currencies with even lower rates)
• British Pound (GBP)
• Turkish Lira (TRY)
• Brazilian Real (BRL)
• Mexican Peso (MXN)
• South African Rand (ZAR)

Common Carry Trade Pairs

• Using Japanese Yen (JPY) as Funding Currency:
  • AUD/JPY
  • NZD/JPY
  • USD/JPY
  • GBP/JPY
  • MXN/JPY
  • TRY/JPY
  • ZAR/JPY
• Using Swiss Franc (CHF) as Funding Currency:
  • AUD/CHF
  • NZD/CHF
  • USD/CHF
  • EUR/CHF
  • MXN/CHF
  • TRY/CHF
• Using Euro (EUR) as Funding Currency:
  • EUR/TRY
  • EUR/BRL
  • EUR/MXN
• Using U.S. Dollar (USD) as Funding Currency:
  • USD/TRY
  • USD/BRL
  • USD/MXN

Benefits of Carry Trades

Interest Rate Differentials: The primary benefit of a carry trade is the potential to earn a profit from the interest rate differential between two currencies. This profit is often referred to as the "carry."

Exchange Rate Appreciation: In addition to the interest rate differential, traders may also benefit from favorable movements in the exchange rate. If the high-yielding currency appreciates against the low-yielding currency, the trader's returns can be significantly enhanced.

Leverage: FX markets typically offer high leverage, which means traders can control a large position with a relatively small amount of capital. This amplifies both potential profits and potential losses.

Risks of Carry Trades

Interest Rate Changes: An unexpected change in interest rates can erode the profitability of a carry trade, given that the main component of the carry trade is centered around the interest rate differential between the two traded currencies. For instance, if the central bank of the high-yielding currency cuts interest rates, the interest differential narrows, reducing the carry trade's profitability.

Exchange Rate Risk: While earning the positive carry, traders are also exposed to exchange rate fluctuations. The value of the target currency may appreciate or depreciate relative to the funding currency. If the target currency appreciates, it can magnify profits, but if it depreciates, it can lead to losses. It is possible for a trader to lose money when the target currency depreciates against the funding currency so that the capital depreciation wipes out the positive interest payments.

Leverage Risk: While leverage can amplify profits, it can also magnify losses. A small adverse movement in the exchange rate can lead to significant losses due to the leveraged nature of carry trades.

Liquidity Risk: In times of market stress, liquidity can dry up, making it difficult to execute trades at desired prices. This can lead to slippage and increased costs.

Global Economic Factors: Political events, economic data releases, and geopolitical tensions can all impact currency values, adding an additional layer of risk to carry trades.

Managing Risks in Carry Trades

Diversification: Diversifying investments across multiple currency pairs can help mitigate risk. By not putting all your capital into a single carry trade, you can reduce the impact of adverse movements in any one currency pair.

Stop-Loss Orders: Implementing stop-loss orders can help manage risk by automatically closing positions at predetermined levels, limiting potential losses.

Monitoring Economic Indicators: Keeping an eye on economic indicators, central bank announcements, and geopolitical developments can help traders anticipate changes in interest rates and exchange rates.

Using Hedging Strategies: Hedging can provide protection against adverse movements in exchange rates. Options and other derivative instruments can be used to hedge positions.