Currency Carry Trades 101

The carry trade is one of the most popular trading strategies in the currency market. Putting on a carry trade involves nothing more than buying a high-yielding currency and funding it with a low-yielding currency. It's similar to the adage, "Buy low, sell high."

The Carry Trade

Two popular carry trades in 2023 involve buying currency pairs like the Australian dollar/Japanese yen and the New Zealand dollar/Japanese yen. The interest rate spreads of these currency pairs can be high but they can vary from day to day. The first step in putting together a carry trade is to find out which currency offers a high yield and which offers a low yield at a particular time.

The interest rates for most of the world's liquid currencies are updated regularly on sites like FXStreet. You can mix and match the currencies with the highest and lowest yields with these interest rates in mind.

New Zealand and Australia have the highest yields on our list and Japan has the lowest so it's hardly surprising that AUD/JPY is often the poster child of the carry trades. Currencies are traded in pairs so all an investor has to do to put on a carry trade is buy NZD/JPY or AUD/JPY through a forex trading platform with a forex broker.

The Japanese yen's low borrowing cost is a unique attribute that's also been capitalized by equity and commodity traders around the world. Investors in other markets have begun to put on their own versions of the carry trade by shorting the yen and buying U.S. or Chinese stocks. This has fueled a huge speculative bubble in both markets and it's why there's been a strong correlation between the carry trades and stocks.

The Mechanics of Earning Interest

One of the cornerstones of the carry trade strategy is the ability to earn interest. The daily interest is calculated like this:

$\begin{aligned} &\text{Daily Interest} = \frac { \text{IR}_\text{Long Currency} - \text{IR}_\text{Short Currency} }{ 365 \text{ Days} } \times \text{NV} \\ &\textbf{where:} \\ &\text{IR} = \text{interest rate} \\ &\text{NV} = \text{notional value} \\ \end{aligned}$​Daily Interest=365 DaysIRLong Currency​−IRShort Currency​​×NVwhere:IR=interest rateNV=notional value​

Imagine the currency you're long on has an interest rate of 4.5%. The currency you're short on has an interest rate of 0.1%. Assuming a notional value of $100,000, you can compute interest as:

$\begin{aligned} &\frac { .0450 - 0.001 }{ 365 } \times \$100,000 \cong \$12 \text{ per day} \\ \end{aligned}$​365.0450−0.001​×$100,000≅$12 per day​

The amount won't be exactly $12 because banks will use an overnight interest rate that will fluctuate on a daily basis.

Why Is This Strategy So Popular?

The returns on straight carry trades aren't very large for most people but these trades are often executed with leverage. Even the use of five- to 10-times leverage can make that return extremely extravagant in a market where leverage is as high as 200:1.

Investors may also favor carry trades because they earn interest revenue even if the currency pair fails to move one penny. This often isn't the case because forex trading typically entails currencies with fluctuating values but there's potential to earn both interest revenue as well as capital appreciation with these types of trades.

Low Volatility, Risk Friendly

Carry trades also perform well in low-volatility environments because traders are more willing to take on risk. Carry traders are looking for the yield. Any capital appreciation is just a bonus. So most carry traders are perfectly happy if the currency doesn't move one penny. The big hedge funds that have a lot of money at stake are perfectly happy if the currency doesn't move because they'll still earn the leveraged yield.

Carry traders will essentially get paid while they wait as long as the currency doesn't fall. Traders and investors are also more comfortable with taking on risk in low-volatility environments.

Central Banks and Interest Rates

Carry trades work when central banks are either increasing interest rates or when they plan to increase them. Money can be moved from one country to another with the click of a mouse and big investors aren't hesitant to move their money around in search of not only high but increased yield.

The attractiveness of the carry trade isn't only in the yield but also in the capital appreciation. The world notices when a central bank is raising interest rates and there are typically many people piling into the same carry trade. This pushes the value of the currency pair higher in the process. The key is to try to get in at the beginning of the rate-tightening cycle and not at the end. 

The profitability of carry trades comes into question when the countries that offer high interest rates begin to cut them. The initial shift in monetary policy tends to represent a major shift in the trend for the currency. The currency pair must either not change in value or appreciate for a carry trade to succeed.

Foreign investors are less compelled to go long on the currency pair and are more likely to look elsewhere for more profitable opportunities when interest rates decrease. Demand for the currency pair wanes and it begins to sell off when this happens. This strategy fails instantly if the exchange rate devalues by more than the average annual yield.

Central Bank Risk

Carry trades will also fail if a central bank intervenes in the foreign exchange market to stop its currency from rising or to prevent it from falling further.

An excessively strong currency could take a big bite out of exports for countries that are dependent on exports. An excessively weak currency could hurt the earnings of companies with foreign operations. The central banks of these countries could resort to verbal or physical intervention to stem the currency's rise if the Aussie or Kiwi should get excessively strong. Any hint of intervention could reverse the gains in the carry trades.

If Only It Were This Easy!

An effective carry trade strategy doesn't simply involve going long on a currency with the highest yield and shorting a currency with the lowest yield. The current level of the interest rate is important but the future direction of interest rates is even more important. The U.S. dollar could appreciate against the Australian dollar if the U.S. central bank raises interest rates at a time when the Australian central bank is done tightening.

Uncertainty, concern, and fear can cause investors to unwind their carry trades.

The Best Way to Trade Carry

One central bank may be holding interest rates steady while another may be increasing or decreasing them. Any one currency pair only represents a portion of the whole portfolio with a basket that consists of the three highest and the three lowest yielding currencies. The losses are controlled by owning a basket even if there's carry trade liquidation in one currency pair.

This is the preferred way of trading carry for investment banks and hedge funds. The strategy may be a bit tricky for individuals because trading a basket would require greater capital but it can still be accomplished with smaller lot sizes. The key with a basket is to dynamically change the portfolio allocations based on the interest rate curve and the monetary policies of the central banks.

Benefiting From the Carry Trade

The carry trade is a long-term strategy that's far more suitable for investors than traders. Investors will be happy if they only have to check price quotes a few times a week rather than a few times a day. Carry traders, including the leading banks on Wall Street, will hold their positions for months if not years at a time. The cornerstone of the carry trade strategy is to get paid while you wait.

Trends in the currency market are strong and directional partly due to the demand for carry trades. This is important for short-term traders because it may be far more profitable to look for opportunities to buy on dips in the direction of the carry than to try to fade it in a currency pair where the interest rate differential is very significant.

Those who insist on fading AUD/USD strength should be wary of holding short positions for too long because more interest will have to be paid with each passing day. The best way for short-term traders to look at interest is to keep in mind that earning it helps to reduce your average price while paying interest increases it. The carry won't matter for an intraday trade but the direction of carry becomes far more meaningful for a three-, four- or five-day trade.

The Bottom Line

A trader attempts to take advantage of differences in interest rates in a carry trade. Rate differences may be small but carry trades are often executed with leverage to enhance profitability potential. Carry trades are often popular in the foreign exchange market. You can begin carry trading by understanding which currencies offer high yields, which offer low yields, and how you can optimize these positions.