To take advantage of the difference in interest rates, currency carry trades include borrowing a low-yielding currency and using it to purchase a higher-yielding currency. This is a crucial component of a carry trading strategy and is sometimes called “rollover.” Traders are drawn to this technique to earn daily interest payments in addition to any currency appreciation from the real deal.

This post shows a top carry trade trading method and an explanation of FX carry trades using examples.

WHAT IS AND HOW DOES A CURRENCY CARRY TRADE WORK?

An FX carry trade is borrowing money in a nation with a low-interest rate (low yield) to pay for the purchase of money in a nation with a high-interest rate (high yield). The trader will get interested based on the “positive carry” of the deal if they keep this position overnight.

The currency with the lower yield is known as the “funding currency,” while the currency with the greater yield is known as the “target currency.”

Rollover

The practice of brokers extending the settlement date of open forex contracts held beyond the daily cut-off time is known as “rollover.” Depending on the direction of the deal (long or short) and whether the interest rate difference is positive or negative, the broker either debits or credits the account. These changes will be the daily adjusted rate since interest is often given as an annual amount.

Rates of interest

Each nation’s central bank determines interest rates in line with the goals of its monetary policy, which varies from nation to nation. When a trader longs the currency in the pair with the higher interest rate, they get interested in their position. For instance, traders may attempt to purchase (long) AUD/JPY to benefit from the 4% net interest rate difference if the Australian dollar provides 4%, while the Japanese Yen has interest rates fixed at 0%.

The FX carry trade primarily consists of two elements:

1) Interest Rate Changes

The difference in interest rates between the two exchanged currencies is the primary part of the carry trade. The trader will earn from the overnight interest payment even if the exchange rate between the two currencies stays the same. The carry trade approach, however, may be in danger as time goes on because central banks may decide it is essential to change interest rates.

2) An increase or decrease in exchange rates

The exchange rate between the two currencies is the subject of the other part of the carry trade strategy. When going long, a trader watches for the target currency to appreciate (grow in value). When this occurs, the trader receives the daily interest payment and any unrealized currency gains. However, the trader’s anticipated profit from the target currency’s appreciation will materialize after closing the deal.

A trader might experience a loss if the target currency depreciates relative to the funding currency to the point that the capital depreciation cancels out the positive interest payments.

Example of a Currency Carry Trade

Using the previous example, if the Australian Official Cash Rate is now at 4% and the Japanese Yen yields 0%, a trader may choose to open a long position on AUD/JPY if they believe the pair will increase.

To profit from the interest rate difference, traders would borrow Yen at a much lower rate than the Australian dollar and pay it back at a higher rate. Since forex brokers often use spreads, retail traders will gain less than 4%.

Please read our article on understanding foreign currency rollover to fully explain how to compute the estimated overnight interest charge/gain.

THE RISKS INVOLVED IN CARRY TRADES

Like any trading method, currency carry trades include some risk. Therefore it’s essential to practice solid risk management. Since the 2008/09 global financial crisis, which led to lower interest rates for developed countries and forced carry traders to go to riskier, high-yielding developing market currencies until interest rates recover, risk management has become even more crucial.

• Exchange rate risk: Traders who are long the pair will see the trade move against them but will still get the daily interest if the target currency weakens versus the funding currency.

• Interest rate risk: If the target currency’s home nation lowers interest rates while the funding currency’s home country raises interest rates, the positive net interest rate will be reduced, likely to lower the FX carry trade’s profitability.

CARRY TRADE STRATEGY FOR FX

One method elite traders use is filtering FX carry transactions in the trend’s direction. This is because the carry trade is a long-term investment, making it essential to study markets that show prominent patterns.

Traders should first search for uptrend confirmation, as is seen in the chart below, following the higher high and higher low to enter higher probability trades.

The chart shows higher highs and lower lows; a break of the horizontal line, which was created at first higher high, indicates an uptrend. Following that, traders may utilize different time frame analyses and indicators to identify the best entry opportunities for a long trade.

CONCLUSION

The exchange rate and interest rate difference are the two potential sources of profit for currency carry traders. Still, risk management is crucial since losses may occur if the pair moves against them or the interest rate differential closes.

For trades with a better chance of success, traders should search for uptrend entry points and use wise risk management strategies to limit downside risk.