The carry trade is often referred to in forex circles and it is a technique smart traders use to profit, not just from movement in a currency but from the interest rate differential between two countries. Countries that have higher interest rates will offer more return on your money than those with lower rates, just like depositing money in a foreign bank will offer a different return.
Essentially then, a carry trade involves borrowing money in a low interest rate account and investing it in a higher rate account and pocketing the difference.
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And since spot forex markets accrue interest daily, it is possible to use the carry trade strategy every day.
One good example of a popular carry trade is AUD/JPY.
Interest rates in Japan have been held at close to zero for years now in order to stimulate economic growth, while in Australia, rates are currently at 2.5%.
The interest rate differential is therefore 2.4% (2.5% – 0.1%).
In other words if you buy AUD/JPY, you will accrue 2.4% in interest on your money and if you use leverage you can increase that return significantly over a year (with additional risk). If the currency also appreciates in that time,like it has done in AUD/JPY, then you will achieve even greater gains.
How to play the carry trade
The best way to play the carry trade therefore is to find a high yielding currency pair that is also likely to appreciate as time goes on. (A 2% interest rate differential is going to be meaningless if the currency you’ve bought drops by 10%).
Generally, a country with good economic prospects will see its currency appreciate more than one that is not doing so well or has poor demographics. You can also look at the interest rate outlooks for both countries. If for example, you foresee Australia dropping rates, and Japan raising rates, your interest rate differential will fall. And it will probably lead to a drop in the currency pair itself too.
When the carry trade works
As you can see, if you play the carry trade correctly, you can achieve a double whammy; Higher interest on your investment as well as capital gains from your trade.
However, there are certain environments when the carry trade becomes ineffective.
During periods of market stress, there is usually an unwinding of the carry trade. In this instance, traders flock to traditional safe haven currencies that offer low rates of return. It’s therefore best to use the carry trade when most traders are optimistic about future returns.
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