Carry trade is a common trading strategy used by forex traders. This strategy allows traders to profit not only from the spread resulting from exchange rate movements but also from interest rate differentials. However, this trading strategy is more suitable for use in normal global economic conditions.When the global economy experiences significant turmoil, central banks may implement special policies to address economic shocks, causing interest rates and exchange rates to become extremely volatile; therefore, this strategy is not recommended.For example, during the COVID-19 pandemic, foreign exchange markets around the world experienced massive volatility. Traders seeking to hedge their positions by closing out positions in low-interest-rate currencies such as the Japanese yen and the euro caused these currencies to appreciate, thereby increasing the risks associated with carry trade.
(I) The Theoretical Basis of Carry Trade Strategies
Exchange rates and interest rates are closely interrelated. If we view interest rates as the price of money, then the exchange rate is the ratio of the prices of the currencies of two countries.A country’s macroeconomic policies influence its interest rates, which in turn affect the exchange rate. During periods of economic overheating, governments generally raise interest rates—for example, by reducing the money supply—to curb inflation. At this time, higher interest rates, as the return on deposits, make deposits in the domestic currency more attractive.
People will sell foreign currency and buy the domestic currency, ultimately causing the domestic currency to appreciate and the exchange rate to fall. This is the relationship between interest rates and exchange rates. By leveraging this relationship, one can use a country’s economic policies to assess its interest rates, thereby predicting exchange rate trends and engaging in carry trade transactions.
(2) Carry Trade Strategy
Forex carry trades primarily rely on holding long-term positions to earn interest rate differentials, making them well-suited for medium- to long-term traders.Simply put, the principle of carry trade strategies is to buy high-yield currencies and sell low-yield currencies. Since the cost of borrowing low-yield currencies is lower, when you borrow a low-yield currency, you use it as the funding currency to purchase a high-yield currency for investment.The profit from carry trading is calculated by subtracting the interest cost paid on the borrowed low-interest-rate currency from the interest income earned on the investment in the high-interest-rate currency. When selecting currency pairs for trading, the following two points should be considered:
First, choose currency pairs with significant interest rate differentials for trading. Common high-interest currencies include the Canadian dollar, US dollar, Australian dollar, and British pound; common low-interest currencies include the Japanese yen, Swiss franc, and euro. When buying the GBP/JPY currency pair, it’s equivalent to borrowing yen, paying yen interest costs, and depositing it in pounds to earn pound interest income. For example, if the yen’s interest rate is 0.5% and the pound’s is 5%, borrowing yen at 0.5% interest, converting it into pounds, and depositing it in a British bank allows you to profit from the 4.5% interest rate differential. Simultaneously, buying the GBP/JPY currency pair is equivalent to betting against the yen, thus profiting from a short position in the yen’s depreciation.
Second, choose currency pairs with relatively stable interest rates or those where the value of a higher-interest currency is trending upward relative to a lower-interest currency. Because carry trades ultimately require closing out the higher-interest currency position and exchanging it for a lower-interest currency to generate profit, the lower-interest currency cannot appreciate relative to the higher-interest currency during the carry trade period; otherwise, the interest rate differential may not cover losses from exchange rate fluctuations. If the lower-interest currency appreciates or the higher-interest currency depreciates, the carry trade will fail. For example, some emerging market currencies, while having relatively high interest rates, are highly volatile; if interest rates fall, the carry trade will fail, resulting in a net loss.
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