Carry trade is a trading strategy where a trader sells a low-risk, low-interest security and uses the proceeds to purchase a higher interest rate security. It consists of borrowing at one set of rates and lending money at another.
Forex traders practice this strategy by borrowing, for example, from Japan, where the interest rates are extremely low and lend their money to other countries such as Australia or New Zealand, whose interest rates are much higher. In other words, carry trade involves taking advantage of different interest rates among two markets with opposite effects on currencies. The main reason for investors’ action in the forex market is the need to generate income from the investment. Still, there are many risks involved in it, too, like fluctuation in prices, which can cause considerable losses to the trader.
Carry trade is primarily made with short-term interest rates, but traders may also include long-term movements in this strategy. In other words, it can be explained as a process for earning money from an asset by borrowing at a low-interest rate and lending at a high one. For example, when Japanese investors buy US treasury bonds or US government bonds, they have to exchange yen for dollars to pay for the bond’s purchase price. This means that if they borrow yen against these bonds in Japan and then retain dollars elsewhere, there will be a currency difference that forms their profit margin. Thus, carry trade is actually about borrowing in low-yielding currencies and investing in higher-yielding currencies until the risk is reduced.
There are two types of carrying trade: back-to-back and manifold. The first one is a simpler version of a complicated strategy. There is no intermediary involved in this process – you sell low-yielding security directly to another investor, which has been bought from someone else. This way, you can avoid paying brokerage fees to your broker to make it easier for you to earn a high yield on your investment compared with other investors who leave their money in short-term deposits without earning much interest. When you engage in this type, be sure that the exchange rate will not fluctuate dramatically so that both of you will be able to translate your profits earned according to losses incurred.
In addition, the manifold form of carrying trade is a more popular type that requires the involvement of many investors. It rolls up the market to find investors willing to provide you with yen against mortgage-backed securities or treasury bills. You then sell these securities for another currency to buy different securities again but with higher interest rates so that you can get rid of your negative yield investment.
Although carry trade inflation does not significantly affect exchange rate movement, it has some effects on currencies over time. Thus, if Japan continues to invest its money abroad through carrying trade, it will help weaken the value of the Japanese Yen over time. However, this phenomenon only occurs if countries have deficits in their current account for several years until they can restore economic growth. Otherwise, if the government raises interest rates to deal with inflation, it may reverse the carry trade effect.
How to profit from carry trade?
The only way to realize a profit from this trading strategy is by taking advantage of the fluctuation in the currency exchange rate, which will occur due to different levels of interest rates among the two countries involved. This is akin to market speculation, where you buy low and sell high or borrow at higher yield and lend money at lower ones. That is why investors are familiar with this type of hedging strategies. It helps them protect their investments against unwanted fluctuations even though they have opposite effects on currencies over time.
Even though this kind of trading may be complicated, the key to success is by acting early on trends that are not yet known to many people. Otherwise, your chances of being successful are slim. You can stay ahead of the pack by joining a trusted FX broker known for sharing accurate news and predictions.