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The Carry Trade : How to Trade Using Interest Rates

The carry trade is one of the most popular strategies in forex trading because it guarantees some type return on medium or long term positions. Unlike most strategies for the forex market, carry trading does not seek to capture a profit by exploiting changes in the value of a currency pair, but instead focuses on the interest rate differentials in currency pairs. The ideal carry trade is one where the currency pair experiences little change in value but has a wide interest rate differential.


What to Look For in a Carry Trade

1.Large interest rate differentials:

For example, the British Pound has a 4.50% interest rate and the Japanese Yen has a 0.50% interest rate. That is an interest rate differential of 4%. This means if you borrow Japanese Yen at 0.50% interest rate and invest it in the British Pound at a 4.50% interest rate, you will make 4% in interest on those borrowed funds.

2.Healthy Economy of the Higher Interest Rate Currency

In general, a country with a high interest rate should attract more foreign capital as investors seek the highest returns on their investments. The health of the economy should also be taken into consideration. For England, inflation above normal at 3% indicates interest rates may rise in the near future, which is typically good for the British Pound. High inflation isn’t always good, especially in the case of Zimbabwe. The interest rate in Zimbabwe as of October 2008 is 8500.00%. A carry traders deam? Absolutely not, with inflation topping 231,150,888.87% year over year in October, investing in this currency would be a very risky move

Popular Carry Trade Set-Ups

Because Japanese interest rates have been so low in the recent past, a disproportionate number of carry trades in the forex market have involved the yen. So, let's use the GBP/JPY for a basic example. Let's say you know for a fact that the yen and the British Pound are going to maintain a parity over the coming year with 0.5% interest for the JPY and 4.5% interest for the British Pound. Taking $10,000 and leveraging it 10:1 to buy100,000 units GBP/JPY you will earn roughly with 11GBP per day on that investment, or 4000GBP per year. With the GBP/USD at an average price of 1.75, you would make roughly $7000 on your investment of $70,000 without a single pip move in your favor. In an ideal situation, like the chart below, investor capital will also flow in the direction of the higher yielding currency and the trader will profit on that as well, but that is not the main goal of the carry trade.

Carry Trade Dangers

Of course, the main danger with carry trading is the same with other types of longer-term forex strategies – the currency you are holding might depreciate against your home currency as is occurring in the chart below. If you suspect that this is going to happen, it is time for you to get out. Many carry traders will set their stops on long term carry trades at their trades entry point. This locks in carry profits and stops the trade before it takes position losses. Keep in mind that carry trading is a long term strategy and should be treated as such, so don’t stress out on intraday profits and losses.