What makes currencies an attractive alternative asset class is the variety of ways they can generate great returns. Today, I want to fill you in on some basics behind the carry trade.

You may have heard the term “carry trade” in the past. Essentially, an asset’s carry is the benefit or cost of holding it over time. A trade based on profiting from holding as asset, then, is called a carry trade. Currency traders are a group that frequently takes advantage of this strategy.

Interest rates are one of the most enduring fundamentals behind currency price movements. When rates are expected to rise, a currency benefits because it attracts more capital. When interest rates are expected to fall, a currency weakens as capital moves out to places with a higher return. The carry trade reflects this basic flow of money.

The carry trade is borrowing low-interest currencies and investing that borrowed capital in higher-yielding currencies. In recent years Japanese interest rates were near zero, so a popular strategy was to sell yen and buy the higher-yields in the Australian or New Zealand dollar. The result was getting very high interest rates (over 6%) as well as growth.

While the precise magnitude of the yen carry trade is difficult to quantify, estimates are that over 1 trillion yen were borrowed to finance carry trades at the height of its popularity.

But during the global financial collapse in 2008, the central banks cut rates to rock-bottom yields, and the carry trade became much less attractive. As time went on, it was even seen as risky. Essentially, the carry trade collapsed in 2008 and 2009, not only due to low interest rates, but also due to high volatility.

However, even though global growth and recovery is far from certain, the environment for a carry trade resurgence is now becoming much more favorable. After all, some central banks are increasing their interest rates, and it looks like the policies of further cuts has stopped.

We are even beginning to see interest rate differentials between central bank rates becoming attractive. For example, the spread between the yen and the Australian dollar is 4.4%. So putting your money into the Australian dollar would yield 4.4% more that you’d make holding yen.

The challenge, of course, is how to benefit from that. We could jump into the spot Forex market. A trader could, for example, sell the JPY, buy the AUD and hold it. In spot trading, they would get paid the interest rate difference between the first currency and the second currency. Of course it would be pro-rated.

But there’s a lot of added risk in the spot market. Trades are subject to fluctuations in exchange rates, not just interest rates. As a result, I wouldn’t recommend this method unless you’re experienced in this market. That said, I’m working on some carry trade opportunities right now that could offer a more accessible way into this lucrative play – hopefully, I’ll be able to share my findings with Penny Sleuth readers soon.

Sincerely,
Abe Cofnas
Penny Sleuth

July 15, 2010

Abe Cofnas

Abe Cofnas has been a full-time analyst of global currency trading for over twenty years and ranks among the top Foreign Exchange (Forex) traders working today. He has written three books on the subject. The most recent, Sentiment Indicators was published in 2010. Cofnas is the managing editor of the Fear & Greed Trader, Agora’s primary source for currencies information. He has also been Futures Magazine’s Forex Trader columnist since 2001, having written over 100 pieces.

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