Carry trade - a currency strategy for the medium and long term

Carry trade is a strategy that uses differences in interest rates in different countries. The interest rates on deposits and loans denominated in the national currency depend on the interest rates of the central bank of a given country. The higher the interest rates, the higher the interest rate on the funds deposited, but also the more expensive the loan. And the lower, the cheaper the loan and the lower the interest rate on deposits.

What is carry trade

The simplest way is to define a carry trade as taking a loan in a low-interest currency (e.g. 0,5%) and exchanging it on the market for a higher-interest currency (e.g. 3,5%). Then we "deposit" in this currency. This is, of course, an interest rate on an annual basis. So, for example, after this time, the investor closes the deposit, receiving 3,5 percent. more funds than he deposited at the beginning. Then it converts the funds into the borrowed currency and repays the loan at 0,5%. Purely without taking into account transaction costs and exchange rate changes, the investor earns 3 percent.

These are purely theoretical assumptions, because the carry trade is burdened with two key risks. A change in the exchange rate that can go in the opposite direction by more than the positive difference resulting from interest rates. The second risk is the interest rate risk and its adverse changes during the transaction.

Therefore, two parameters are important for the carry trade. The first is the measure of expected volatility on the exchange rates of currency pairs, and the second is the expectations for interest rates in the future.

INTEREST RATES IN THE WORLD

In the best-matched currencies a carry trade can be used to borrow currency for which interest rates are expected to decline or not to be changed in the long-term and to deposit funds in a currency that is of course higher interest today and there are chances for further hikes in the future (or rates not change).

If today the interest rate for the YYY currency is higher, and for ZZZ lower, and interest rates for ZZZ are expected to increase, and for YYY to fall, then most likely such a strategy will not function properly.

In turn, in the case of expected volatility, the lower it will be, the better for the carry trade. This is due to the fact that then the risk of an unfavorable course change is lower because the overall range of movements anticipated is lower. Then the chances that an increasing number of investors will start to be interested in the carry trade increase. This, in turn, will lead to a favorable change in the exchange rate, which will bring potential greater returns than the interest rate difference alone.

Swaps are key

Na the forex currency market traders / speculators have the option to sell and buy currencies at the same time based on currency pairs. The difference in interest rates for currencies in a pair is, in turn, visible in the so-called swap pointswhich should be positive for a position in which we buy a currency with a higher interest rate and sell a currency with a lower interest rate and vice versa. It is worth checking with your broker how it calculates swap points and whether it accidentally imposes an additional margin. It will be visible when one currency in the pair has higher interest, the other one lower. Regardless of whether the swap will be negative for a long or short position. Then it can be clearly stated that broker has an additional mark-up constituting his profit and discouraging him from trading in the medium to long term.

It is also worth remembering that the risk approach is also important for carry trade. The main world economies have a similar, very low, degree of investment risk. Nevertheless, in recent years the difference in interest rates between them has significantly decreased. Hence, some investors look at the emerging market economies, where rates are higher, but the risk also. This approach must always be well calculated before making any decision.