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Forex Course

193. Summary – Carry Trading

Introduction 

Carry trade involves borrowing or selling of an asset that has a low-interest rate, for the purpose of using the fund proceeds to make another investment with a higher rate of interest. By paying a lower rate of interest on assets and collecting a higher interest rate from another asset, traders make a difference in the interest rate.

Currency Carry Trading – How Does It Work?

In currency carry trading, the trader borrows one currency known as the borrowing fund. And, then they use this fund to purchase another currency. The traders pay low-interest rates on the borrowed currency while collecting a higher interest rate on the purchasing currency. This type of trade gives traders an effective alternative to purchasing low and sell high, which is difficult to do on other trading options. AUD/JPY and NZD/JPY are the most common currency pairs to carry trade.

Opportunities & Risks Involved

The most profitable time to perform a carry trade is when the country’s central banks are increasing or about to raise the interest rate. Low volatility situations are also profitable for these trades as traders are more likely to take more risks. Granted that the value of the currency does not fall, traders are likely to get a good amount.

There is a big risk associated with currency carry trading, primarily because of the uncertainties associated with the exchange rate. When high leverage levels are used in this trade, it implies that even small movement in the exchange rates can result in a substantial loss if the traders fail to hedge their positions properly.

Risk Management 

While lucrative, carry trading comes with its own share of risks. This is because currencies are prone to volatility. Moreover, the negative market sentiment of the traders within the currency market can also have a substantial impact on carry pair currencies. Without improper risk management, traders could end up bearing a high degree of risk. The best way to avoid risk in a carry trade is when the market sentiment and fundamentals support them.

Final Thoughts

If you are looking to invest in a carry trading, the first steps are to select the most lucrative broker vs currency pair combination. The charges of brokers vary significantly across various currencies. Therefore, it is important to ensure that the trade offers an effective risk-adjusted return. Cheers.

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Forex Course

192. Criteria To Carry Trade The Forex Market and Risks Involved

Introduction

In the previous lesson, we discussed instances when a carry can work, and when it’s bound to fail. But, having this knowledge won’t be of much help if you do not know the best criteria for a currency carry trade and the risks involved.

Criteria to Carry Trade

There are two basic criteria to carry trade the Forex market profitably.

The interest rate differential between two currency pairs needs to be high with no prospects of reducing in the near term.

The currency pair that we choose has to be on a bullish trend in favor of the currency with the higher interest rate. The reason for this is to ensure you can remain bullish on the high yielding currency and profit from the interest rate differential for the longest possible time.

Let’s take the example of the AUD/JPY pair. Japan’s interest rate has remained at -0.1%, while in Australia was held at 0.25%. That means the interest rate differential between the AUD/JPY pair has been 0.35%. Therefore, if you were to borrow and sell the JPY to buy the AUD, you’d expect a pay-out of 0.35%. Note that this is the same as going long on the AUD/JPY pair.

In this scenario, going long on AUD/JPY from March 2020 to October 2020 would have earned you over 900 pips. At the same time, you’d be earning an interest rate differential of 0.35%.

Risks Involved In Carry Trading

So far, a carry trade sounds like a risk-free strategy. But, like any other investment, the carry trade has its fair amount of risks – especially when leverage is involved.

Remember, in the previous lesson, we mentioned two conditions for a carry trade to thrive. First, there had to be low volatility in the market. The reason for this is to ensure that your open position is not wiped out due to currency fluctuations before you reap the profits of interest rate differential. Note that using trailing stop orders can help mitigate the risk of price fluctuations in the forex market.

The second condition for a carry trade to thrive was the stable economic conditions that might encourage the hiking of interest rates. If the economic climate is full of uncertainties, like with the ongoing coronavirus pandemic, central banks are more likely to cut interest rates than hike them. Therefore, if extreme interest rate cuts occur while you are in a currency carry trade, it could result in losses. 

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Categories
Forex Course

190 – Introduction To Carry Trading The Forex Market

Introduction 

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.

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