How to use the currency carry trade strategy

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By :  ,  Financial Writer

What is a carry trade in forex?

Carry trades are a forex trading strategy that seeks to profit from the interest rate differential between two currencies in a given currency pair. Carry trades can apply to both long and short trades.

For example, a long carry trade involves borrowing a low-yield (low interest rate) currency to buy a higher-yield (high interest rate) currency and profiting from the difference in interest rates. The Australian dollar/Japanese yen and New Zealand dollar/Japanese yen are popular forex carry trade pairs because of their high interest rate spreads.

Interest rates are quoted as a yearly average but can change any day at the whims of central banks. However, some countries seek to maintain a low or high interest rate for an extended period in accordance with their economic policy, allowing traders time to profit using carry trades. Typically, a currency carry trade is kept open for several months.

At face value, currency carry trades may seem like a low-risk strategy, but there are pitfalls you should be aware of. For example, a minor depreciation of the target currency can be enough to quickly erase any gains from the interest rate differential. Carry trades are most effective when the currencies you’re using are experiencing little volatility.

How does a forex carry trade strategy work?

The carry trade strategy works by exploiting different rates of currency appreciation driven largely by inflation and interest rates. In a carry trade, you borrow a low-yield currency to buy a higher-yield currency, allowing your funds to appreciate faster than if they were denoted in the low-yield currency.

How interest rates work in forex

Forex interest rates, also known as rollover rates, are charged as daily fees for holding your positions overnight. These interest rates can be negative or positive, so they’re important to consider in any forex trading strategy, not just carry trades.

Rollover rates are based on current interest rates set by central banks. They tend to be stable during normal market conditions but can change drastically overnight if the interbank market becomes stressed or central banks decide to change rates. It’s useful to keep a calendar of central bank rate decisions on hand so you’re not caught off guard.

Rollover rates are executed at 10pm GMT because the New York trading session is usually seen as the last, with the Sydney session ‘opening’ the next day. The forex market is open 24 hours a day, 5 days a week, closing at 9pm GMT on Friday and opening again on Sunday at 10pm GMT. To account for the closed days, Wednesday’s rollover rate is tripled. 

Best carry trade forex pairs

The best currency pair for carry trades involve currency pairs with a high-interest rate base currency and low interest rate secondary currency. In this case, the secondary currencies are most important.

Two popular secondary currencies for positive carry trades are the Japanese yen (JPY) and the Swiss franc (CHF). Traders have more options when it comes to high-yield base currencies. Popular ones include the Australian dollar and the euro. Other currencies pairs that represent stable economies and low-risk countries include USD/CHF, USD/JPY, CAD/CHF, and NZD/CHF. These are all examples of currencies pairs with high interest rate spreads and stable economies.

How to make a carry trade in forex

You can make a carry trade with City Index. Place your trade 24-hours a day, five days a week – from 9pm (GMT) Sunday evening to 10pm (GMT) Friday night on our award-winning platform. You’ll have the choice of trading 80 global FX pairs with competitive spreads.

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Currency carry trade example

In this example we will show how a long carry trade works with AUD/JPY, a popular currency pair for carry trades. Let’s say the Australian central bank has set a 3.6% interest rate while the Japanese yen is currently set at a 0.1% interest rate.

To capitalise on the 3.5% interest differential, you would sell JPY to buy AUD. To keep it easy you buy 100,000 AUD with 9,000,000 JPY at an exchange rate of 90 JPY = 1 AUD.  

As long as the spot rate remains constant, you will gain 3.5% interest after one year. That means your position grows to 103,500 AUD. That’s a gain of $3,500. Carry trades can be even more lucrative when you trade on margin. A 20:1 margin requirement, or 5%, means you only need $5,000 AUD to open a $100,000 AUD position, making the $3,500 gain a 70% profit. Margin requirements vary for each currency pair, you can view all margin requirements here. 

Of course, any change in the spot rate of AUD/JPY can impact your trade. If the exchange rate moves to 85 JPY = 1 AUD when you close your trade, you’ll only receive 8,797,500, a smaller amount than you opened the trade with. The carry trade strategy is fairly simple, but this is one of several risks that can ruin the method. Risks of carry trades

Because carry trades rely heavily on interest-rate spreads between two currencies, any change made to either currency’s interest rate by that country’s central bank can drastically affect your trade. Additionally, if the currency pair’s exchange rate moves against you during your trade, all your profits from the interest rate differential may be wiped out when you close the position.

For example, the Japanese yen is a popular funding currency for carry trades because the country seeks to maintain near-zero interest rates. But during the credit crisis of 2008, interest rates for high-yield currencies like the euro and US dollar were slashed. Japanese investors rushed to pull out of overseas investments and reinvest in the yen, causing the currency to appreciate and carry trades involving the yen to unwind as the interest differential between currencies became insignificant and the exchange rates reversed.

Benefits of carry trades

Carry trades have several advantages beyond the addition of interest earnings on top of your trading gains. The interest payments made by your broker are on the leveraged amount, so if you open a trade for one lot (100,000) you may only need $2000 depending on your broker’s margin requirements. However, the interest paid by your broker is on the entire $100,000, not just the $2000 of your own funds.

Carry trading can return regular profits when markets stay relatively stable, which makes it a popular strategy during times of low volatility. However, as with any forex trade comprehensive risk management is essential—so make sure you have your stop-loss and take-profit orders set up before entering the position.

Try your carry trade strategy now with City Index

Test your carry trades in a risk-free environment with a City Index demo account

Or, if you’re ready to start trading live currency pairs, follow these easy steps to open your first position:

  • Open a City Index account, or log in if you’re already a customer
  • Search for a currency pair with a large interest-rate spread in our award-winning platform
  • Chose your position and size, and your stop and limit levels
  • Place the trade

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