Make Money With Carry Trades
The carry trade is a relatively simple idea but it has been at times a very profitable way to trade the market. This has been especially true when currencies stay relatively stable. A carry trade is when the trader purchases a high yielding currency and at the same time sells a low yielding currency.
These trades are profitable for two different reasons. Firstly the word carry comes from the interest differential between the two currencies. If you are long a higher yielding and short a lower yielding currency then their will be a differential in your favour. Traders also benefit as the spot price appreciates. When one currency has higher interest rate than another over time the currency pairs move in favour of the higher yielding currency. This is due to the fact that because of the rewards of holding the higher yielding currency more buyers are interested in buying that currency. Those who are short the high yielding currency suffer and this lowers interest in selling the currency.
All this makes trading the currency markets seem very simple. All it would seem you need to do is buy high yielding currencies and sell low yielding ones. However it is not quite as easy as that. Interest rate differentials tend to be quite small. Any volatility in the spot price can quickly remove any gains that have been made from holding the higher yielding currency. Also the carry trade is very popular with institutional investors. This means that profitable carry trades can quickly get swamped by other deep pocket traders.
As mentioned at the start of the article carry trades are usually best applied in low volatility environments. You want your currency pair to be relatively stable so that your gains from the interest rate differential and hurt by moves in the currencies. Also the differential between the two currencies needs to be reasonably significant to make the trade worthwhile.
One of the most famous examples of the risks of the carry trade was the 2008 Icelandic Financial Crisis. Loans made out in Euro’s had been used to purchase homes and other assets in Iceland. The majority of these loans defaulted when the Euro appreciated rapidly increasing the loan repayments to unserviceable highs.
Most of the carry trade is centred around Japan however where it is known as the Yen Carry Trade. In Japan the lending rate is close to zero which is the lowest for any major currency. Countries such as New Zealand and Australia over the last ten years have had relatively high interest rates of around 6 – 8%. Thus it has been possible to short the Japanese currency and go long currencies like the New Zealand and Australian dollar and profit handsomely. By 2007 there was some $US1 trillion in play on the yen carry trade. This gives you some idea of the scope of this trade. The collapse of the trade in 2008 was mostly blamed on the rapid appreciation of the yen. This trend was accelerated as those holding unfavourable positions tried to cover their debts in the yen tried to convert foreign assets into the currency, thus accelerating the process. This reversal in the carry trade was also one of the central reasons that the credit crunch and the great financial crisis was so severe.