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How the carry trade works

The carry trade is rather straightforward in theory. A currency often has an interest yield associated with it. This interest rate is called the overnight rate, and is set by a central bank. If a foreign currency is associated with a low rate, its assets yield lower returns. In the carry trade, a low yielding currency is borrowed. The borrowed currency is then used to purchase units of a higher yielding currency. A forex trader can make money on the difference in the yield.

Making money on the forex spot market works in this way because interest payments are made every day – at the end of the day – depending upon your position. Forex brokers close out all positions on the spot forex market at the end of every day. (If you hold your position into the next day, you get it reopened automatically.) At the time of the close out of the FX trading positions at the end of the day, you make money on the yield differences between the currency you borrowed and the currency you bought with the borrowed funds.

One of the most popular carry trade options in currency trading is the Japanese yen carry trade. The yen is traditionally one of the lowest yielding currencies (right now Japan’s benchmark rate is at 0.1%), and is quite popular as a funding currency. Often, yen is used to fund the purchase of the Australian dollar (the benchmark for the Reserve Bank of Australia is 3%). You can see how much of a difference there is between the two rates, and the kind of profit that is possible, depending on your position. The Swiss franc is also popular as a funding currency, due to its traditionally low yield. The New Zealand dollar and the U.K. pound are both popular as purchased currencies because of their usually higher rates.

It is important to be aware of the risks, however. It is possible to lose money quickly on the carry trade if circumstances on the volatile forex market change.

Tags: Forex Trading