When it comes to forex trading, we have so far covered how you can make money by taking advantage of price fluctuations. What, then, do you do when the price of a currency pair remains relatively stable for extended periods? Certainly not nothing! You carry trade.
In the financial market, carry trade means borrowing a financial asset with a low-interest rate, sell it, and purchase another one that pays a higher interest rate. That means the cost of borrowing (lower interest rate) is lower than the proceeds (higher interest rate). In this case, the profits you earn is the difference between the two interest rates, also known as interest rate differential.
For us to explain how the carry trade works, we first need to explain how the interest rate in the financial market works.
Carry Trade Example
Say you go to a bank and take a loan at an interest rate of 2% per annum. If the loan amount is, say, $2000, the interest charged per year would be:
= 2/100 * 20000 = $400
Now, instead of putting the money under a mattress, you decide to buy a corporate bond, which in total, pays a yearly interest rate of 10%. This means that at the end of one year, you should expect interest income of:
= 10/100 * 20000 = $2000
In this scenario, you have earned $2000. Remember, the borrowing cost was $400, which means you have a profit of $1600. In other words, you have earned an 8% in terms of interest rate differential.
If that doesn’t sound like much money, let’s see how you feel when we apply leverage to the borrowing.
Leveraged Carry Trade Example
Say you have a stock portfolio worth $20,000 and put this up collateral for a $2,000,000 loan with an annual interest rate of 2%.
You take this money and invest in another financial asset that pays an annual interest rate of 10%. In this scenario, the interest rate differential is still 8%. How about your profit?
= 8/100 * 2,000,000 = $160,000
With collateral of $20,000, you have made a profit of $160,000. That is an equivalent of 800% return.
Currency Carry Trade
In the forex market, if you let your position stay overnight, you will be charged a rollover fee. The rollover fee is the interest rate differential between the two currencies in the currency pair. Your account will be debited or credited accordingly, depending on whether the interest rate differential is positive or negative.
Stay tuned to learn more about Carry Trading in our upcoming articles.