Carry Trade

In general, the forex trading strategy known as the "Carry Trade" refers to an increasingly widespread forex
trading strategy that is usually implemented over longer term time frames and involves taking advantage of the interest rate differential prevailing between two currencies.

Furthermore, using such an interest rate strategy in your forex trading will make the most sense if you use a forex broker that provides particularly attractive rates on rollovers for the currency pair you are most interested in putting on a carry trade with.
Profiting From Interest Rate Differentials

Since carry traders basically look to capture the interest rate differential between two currencies, as well as hopefully some additional appreciation from favorable exchange rate movements, they need to choose their pairs wisely based on two primary criteria.

The first is the magnitude of the interest rate differential itself. The absolute value of this differential can be readily computed by subtracting the higher interest rate from the lower interest rate for each currency involved. The interest rates used will be those prevailing for Interbank deposit rates for the time period during which the carry trade will be kept on for.

The second consideration is the likelihood of appreciation of one currency versus the other. Since carry trades tend to be longer-term positions, a combination of fundamental and technical analysis is often used to arrive at this forecast.

For the best carry trade scenario, you will want to choose the highest interest rate currency that stands the best chance of appreciation against the lowest interest rate currency according to your forecast for the future exchange rate over your time frame of interest.
Carry Trade Profits and Risks

Not only do carry traders hope to capture the resulting favorable interest rate differential or "positive carry" as it is often called, but they usually also plan on benefitting from interest rate compounding effects, as well as from any currency appreciation seen.

The sum of these factors at the time the trade is closed out will determine their profit or loss on the carry trade.

In terms of risk management, the interest rate differential provides something of an initial protective buffer against losses that might accrue due to adverse exchange rate movements. Nevertheless, stop losses can be placed at strategic points that stand a reduced chance of being executed as an additional form of risk management. Learn more about the risks with carry trading.
Additional Profits or Costs of Rollovers

Rollovers of currency positions tend to be executed automatically by most online forex brokers if the position is held over the time of 5 PM Eastern Standard Time.

An automatic rollover means that the broker will automatically close out your existing forex position for value spot and roll it forward for value one additional business day in the future. Since rollover rates can vary substantially among forex brokers, make sure you choose a broker with competitive rollover rates if you intend to put on carry trades.

Generally, when forex traders have their currency positions rolled, they will get paid pips to do so if they are holding the higher interest rate currency. On the other hand, if they are holding the lower interest rate currency, they will pay pips away when their position is rolled over.
Hedged Carry Trades

Yet another type of carry trade involves hedging one long carry trade with another short carry trade using different currency pairs that are closely correlated and which results in a net interest rate benefit to the overall position.

For example, a hedged carry trader might exploit interest rate differentials between well correlated currency pairs like the following:

EUR/USD and USD /CHF

AUD/USD and NZD/USD

GBP/USD and USD/CHF

EUR/JPY and CHF/JPY

GBP/JPY and CHF/JPY

Such hedged carry trades are often highly leveraged to make them worthwhile, thus much more risky. Nevertheless, the main risk to this hedged carry trade strategy arises if the correlation between the pairs breaks down for some reason and subsequently results in losses. Remember that the correlation risk is of course not the only risk factor to consider, just one of them.
The Effect of Risk Aversion and Appetite on the Carry Trade

When risk aversion prevails among investors in the forex market and exchange rate volatility is high, the carry trade often starts to look less attractive since the riskier currencies to invest in tend to have higher interest rates.

On the other hand, when all seems well in the world and more stability has returned to the currency market, the risk appetite of investors then tends to increase and they start looking for higher returns on their money, even if it means taking more risk.
The Benefit of Compounding Interest

Another interesting element that favors the carry trade is the possibility of compounding your interest on a daily basis by rolling your carry trade positions over each day.

When the rollover spreads available for doing so are reasonably competitive, this can provide even more income for the carry trade compared with just rolling the carry trade position out for an extended period using a forex forward contract.

Read about the powerful effect compound interest has on the carry trade strategy.

Read our main article on carry trading.

See our comprehensive technical analysis section.

See our comprehensive fundamental analysis section.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.
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US Dollar Smashed by Fed, Bernanke; Aussie Up on Jobs, Yen on BoJ

ASIA/EUROPE FOREX NEWS WRAP

The Dow Jones FXCM Dollar Index (Ticker: USDOLLAR) is down modestly on the day, having recovered half of its losses this week following dovish saber rattling from the Federal Reserve. Price action today has been largely dictated by what began on June 19, when the Fed suggested that it could wind down is QE3 easing program by mid-2014, given the recent improvement in the US labor market. From the low on June 19 to the yearly high set on Monday, July 8, the USDOLLAR rallied by +4.74%.

The optimism surrounding the US Dollar was dispelled quickly yesterday after the Fed’s June meeting Minutes showed the policymakers remained split over the timing of when to end QE3, and then at a policy speech after the US cash equity close when Chairman Bernanke said that tapering QE3 wouldn’t mean the Fed’s accommodative policy stance would change. This is important because it highlights the distinction between “tapering” and “tightening”: the Fed has merely indicated that it will slow, not stop, its easing measures.

It is of little surprise that the other majors, berated by the US Dollar since mid-June, have made a strong comeback. In fact, since Monday’s high, the USDOLLAR is now off by -1.69%, and was down by as much as -2.19% overnight. The Australian Dollar has posted modest gains following an improved June Australian labor market report, while the Japanese Yen has garnered favor following the Bank of Japan’s policy hold earlier today.

Read more: British Pound Plummets to Lows, but is it Too Much Too Soon?

Taking a look at European credit, peripheral yields have jumped on the day while core yields have fallen; putting upward pressure on Italian- and Spanish-German spreads (typically a sign of Euro-Zone sovereign debt crisis stress). The Italian 2-year note yield has increased to 1.662% (+9.2-bps) while the Spanish 2-year note yield has increased to 2.072% (+7.3-bps). Likewise, the Italian 10-year note yield has increased to 4.476% (+3.2-bps) while the Spanish 10-year note yield has increased to 4.838% (+4.9-bps); higher yields imply lower prices.

RELATIVE PERFORMANCE (versus USD): 10:45 GMT

CHF: +1.11%

GBP: +0.85%

CAD: +0.79%

EUR:+0.75%

NZD:+0.68%

AUD:+0.57%

JPY:+0.47%

Dow Jones FXCM Dollar Index (Ticker: USDOLLAR): -0.57% (-0.84% prior 5-days)

The US Dollar tumbled in overnight trade after Ben Bernanke clarified the Fed’s intentions to “taper” QE asset purchases. More of the same is expected ahead.

Talking Points

• US Dollar Tumbles as Bernanke Reins in QE “Taper” Speculation
• Buoyant Risk Appetite Points to Continued Dollar Selling Ahead

The US Dollar tumbled in overnight trade, losing as much as 1.5 percent on average against its top counterparts, as Asian markets responded to yesterday’s “dovish” commentary from Federal Reserve Chairman Ben Bernanke. The central bank chief pushed back against speculation about a near-term reduction of QE, reminding investors that the “overall thrust” of policy remains highly accommodative. Bernanke added that inflation and job growth trends signal that more Fed stimulus is needed.

Minutes from June’s FOMC policy meeting seem to illuminate the impetus behind the Fed Chairman’s tone. Officials debated including specific language about the fate of the asset purchase program in the policy statement but ultimately felt it was too difficult to “convey succinctly the desired information.” As such, much of the discussion focused on how Bernanke ought to explain the central bank’s intentions in the press conference following the sit-down, with most participants stressing that he should:

1. Make clear that any changes to the asset purchase program remained highly conditional on an ongoing assessment of the economic outlook.
2. Strike a clear distinction between “tapering” and “tightening”, stressing that there is likely to be a significant time lag between the end of QE and an increase in the benchmark lending rate.

In retrospect, those FOMC members who feared that “stating an intention to slow the pace of assetpurchases...might be misinterpreted as…the initial step toward exit from the [Fed’s] highly accommodative policy stance” proved correct.Indeed, the mass liquidation of QE-linked bets in the aftermath of June’s FOMC meeting suggests the markets interpreted the Fed’s posture as having shifted significantly toward the hawkish side of the spectrum.

With that in mind, today’s comments from Mr Bernanke represent not an about-face in the Fed’s thinking but an attempt to realign the markets’ perceptions. The reality of the Fed’s intentions has not changed, but volatility in asset prices since Bernanke spoke shows that the markets’ perception of those intentions is undergoing significant reassessment.

More of the same seems likely to ahead. European shares are on racing higher in early morning trade and S&P 500 futures are up by nearly a full percentage point as traders cheer the prospect of longer-lasting Fed support. A quiet economic calendar offers little that can derail momentum, pointing to continued US Dollar weakness ahead.