Carry Trade: Exploiting Interest Rate Differentials to Maximize Profits

Carry trade is one of the most unique aspects of the currency markets. In a nutshell, a carry trade exploits an interest rate differential that exists between two countries; positive carry trades add value and negative carry trades decrease profits.

Carry trade is one of the most unique aspects of the currency markets. In a nutshell, a carry trade exploits an interest rate differential that exists between two countries; positive carry trades add value and negative carry trades decrease profits.


Example:  as of the date of this article, Bank of England maintains its benchmark short-term rate at 5.75% annualized and Bank of Japan has a target rate at 0.50% annualized, thus creating a carry trade of 5.25% interest rate differential. A trader initiates a carry trade by borrowing Japanese Yen at 0.50% and than purchasing British Pound at the market rate, then subsequently investing it at the prevailing interest rate, which is 5.75%. When the interest payment is received in Sterling and subsequently repaid in Japanese Yen, the trader carry trade profit is 5.25% annualized, paid in Pounds.


The other side of the carry trade is when the trader trades against the carry” he must pay the interest rate differential, or carrying charges.


Example: Trader decides that EUR/JPY is due for a correction and decides to take a swing trade against the carry. European central bank currently maintains its benchmark landing rate at 4.00%, while Bank of Japan target rate is 0.50%, thus creating an attractive carry trade of 3.50% annualized payable in Euro. When the trader decides to take an advantage of market volatility and sells EUR/JPY, he will have to borrow Euro at 4.00% annualized, then sell them and purchase Japanese Yen and invest at 0.50% annualized. The trader’s carrying charges are then 3.50% annualized and payable in Euro. In this case, the trader is not looking to take advantage of the existing carry trade, but instead looking to profit from the decline in the value of the Euro exchange rate against Japanese Yen. The downside of trading against the carry trade is that the trader must factor in the value of the negative carry into the risk/reward ratio, and be aware that a lack of movement in a negative carry trade will still result in a loss despite lack of price movement and volatility.


A trader must be aware of how carry trades impact overall market direction and money flow. If a trader is a day trader he will most likely have little or no benefit from the carry trade, as the trade will most likely be closed before the carry can take effect. The advantage of such trading is that the trader will not incur any interest charges when trading against the positive carry, but on the flip side he won’t benefit from the positive carry, either.


Carry trade only comes into play when the trader is a swing trader, a position trader, or a trend follower. As a swing trader, where he takes a position over a few days to capture short-term fluctuations, interest rate differential will most likely have an insignificant impact on the profitability of the trade due to the fact that the carry trade was only few days long.


Real carry trade will come into play if the trader has a long-term horizon and his trades last longer than a few weeks. A position trader who takes positions that can last weeks or months at a time must be aware that the existing carry trade, as long-term trade that is placed against the carry, will have a significant impact on the profitability of the trade.


Example: if a position trader decides that NZD/JPY is due for a long-term correction and shorts New Zealand dollar, which has an inertest rate of 8.25% annualized and payable in NZD, while simultaneously purchasing Japanese Yen with a yield of 0.50%, he is trading against a 7.75% annualized carry trade, and the costs of such trade can be tremendous and must be factored in into risk versus reward. It does not pay to sit and wait for the market to move when trading against the carry. A trader must be aware of momentum and only then trade against the carry, because profits from the trade will most likely far outpace the losses from paying the carrying charges.


The most beneficial way to trade against the carry is to be aware of the carry trade liquidation; these moves do not occur often, but the sheer magnitude and the speed of the decline in the exchange rates can lead to substantial gains in a very short period of time. There were times when carry trade liquidation would cause the exchange rate to retrace over 70% of the previous move, which took months or even years to develop, in just a few days. So traders must always be aware of the danger of an overextended carry trade.


The very nature of carry trade lends itself to the long-term traders, especially trend followers. The way carry trade is created in the market is when a widening of the interest rate differentials between two countries occurs.  That usually occurs when one country is going into a tightening credit cycle and its central bank is consistently raising rates, while the other country’s central bank is either maintaining its benchmark rate or is in the process of lowering it. Trends begin to manifest themselves when the carry trade begins to form when interest rate differential widens or tightens and the market subsequently begins to react and price in future interest rate hikes and/or cuts, thus creating price trends with exchange rates moving higher or lower depending on the direction of the carry trade. Carry trade coupled with trend following creates profitable opportunity for a long-term trader, especially on the positive side of the carry trade, where trade remains profitable even though the market can go through periods of minor retraces and consolidation ranges. 


As a trader, one must be always aware of the carry trade in the currency market and use it to maximize ones returns and minimize ones losses and carrying charges.