How to Benefit From the Currency Carry Trade

A currency carry trade can be one of the riskiest, yet one of the most profitable, ways to make money in Forex. Even though this method of trading can be very risky, it is also very simple — mechanically speaking. Once you get the basics down, and once you have executed the trade, all you have to do is hold onto the currency pair for as long as it remains profitable.

What Is the Carry Trade?

The carry trade refers to a very specific trading strategy where you borrow a currency that pays (or earns) a low interest rate and invest the borrowed funds into a currency that pays a higher interest rate. You make money on the difference. One of the more famous examples of this is the yen carry trade. The yen carry trade happened at a time when investors and speculators could borrow Japanese yen from a Japanese bank. Those investors then converted the currency to US dollars and bought bonds that paid at least as much as what the loan was costing them.

If a Japanese bank charged interest at 1 percent, or even 0 percent, and the US bond paid 4 or 5 percent, then the investor made several percentage points profit. As long as the spread between the borrowed funds and the bond rates remain positive, the investor can "carry the trade" forever.

How This Applies to Forex

One of the most popular ways to make money in the foreign exchange market is to take advantage of interest rate difference. Because Forex employs leverage, the profits from a traditional carry trade can be magnified. For example, if banks and corporations in Australia are paying 5 percent on bank CDs, bonds, and other fixed interest investments, then the Australian dollar (AUD) might pay an interest rate of 5 percent. If Japanese banks are charging .5 percent for loans, then the Japanese yen might charge .5 cost the investor .5 percent. There is a profit opportunity there.

An investor with an appetite for risk enters the Forex market and goes long on the AUD/JPY pair. The investor would carry the trade overnight. The difference in interest rates means that the investor is paid a net of 4.5 percent (5 percent earned on the AUD and .5 percent paid to carry the JPY).

The carry trade is considered a long-term investment strategy, so you should not be thinking in terms of intra-day trends or short-term technical analysis. In fact, currency carry trades are often predicted using fundamental analysis, since it is largely a nation's central bank that determines (or heavily influences) interest rates in the marketplace.

When to Use the Carry Trade

The carry trade is really only effective when the marketplace has a high appetite for risk. When an economy softens, retail investors and institutional investors get nervous about the safety of their capital. Money managers are responsible for millions, sometimes billions, of dollars of other peoples' money. They cannot afford to take crazy risks with the bulk of the portfolio. What do they do? When times are tough, they do what most people would do: they stash a large chunk of the portfolio's money into safe investments.

If enough money flows into safe investments like investment-grade bonds and government-issued securities, the arbitrage provided by the carry trade might disappear altogether because currencies with low interest rates will appreciate against high interest rate currencies due to the demand from scared investors. In other words, the 4.5 percent rate difference may become too small to cover the losses on the high-yielding currency due to its depreciation and the yen's appreciation. If you are not careful, the leverage could put you into a position where you owe the brokerage money. One of the best ways to avoid this kind of fate is to educate yourself. The more you know about a nation's currency, its government, and what affects its interest rates, the better your investment decisions will be.