[John Smith]

Carry Trades: An Opportunity to Profit from International Changes in Supply and Demand

Money is constantly flowing in and out of different markets, driven by the economic law of supply and demand: markets that offer the highest returns to investment will in general attract the most capital. Countries are no different—in the world of international capital flows, nations that offer the highest interest rates will generally attract the most investment and create the most demand for their currencies.

In foreign exchange trading, the carry trade is an easy way to take advantage of this basic economic principle. A very popular trading strategy, the carry trade is simple to master. If done correctly, an investor can earn a high return without taking on a lot of risk. However, carry trades do come with some risk. The chances of loss are great if you do not understand how, why, and when carry trades work best.


How Do Carry Trades Work?

The way a carry trade works is to buy a currency that offers a high interest rate while selling a currency that offers a low interest rate. Carry trades are profitable because an investor is able to earn the difference in interest—or spread—between the two currencies.


An example: Assume that the United States dollar offers an interest rate of 5.25%, while the Japanese Yen offers an interest rate of 0.25%. To execute the carry trade, an investor buys the United States dollar and sells the Japanese Yen. In doing so, he or she can earn a profit of 5.00% (5.25% in interest earned minus 0.25% in interest paid), as long as the exchange rate between United States dollar and Japanese Yen do not change.

To illustrate, here is how an investor would actually execute the carry trade:


Diagram 1: Executing the Carry Trade.

Buy USD/ Sell JPY

- Long USD position: investor earns 5.25%
- Short JPY position: investor pays 0.25%
- With spot rate held constant, profit is 5.00%, or 500 basis points




To summarize: A carry trade works by buying a currency that offers a high interest rate while selling a currency that offers a low interest rate.

[Student]

Originally Posted by John Smith

Carry Trades: An Opportunity to Profit from International Changes in Supply and Demand


Money is constantly flowing in and out of different markets, driven by the economic law of supply and demand: markets that offer the highest returns to investment will in general attract the most capital. Countries are no different—in the world of international capital flows, nations that offer the highest interest rates will generally attract the most investment and create the most demand for their currencies.

In foreign exchange trading, the carry trade is an easy way to take advantage of this basic economic principle. A very popular trading strategy, the carry trade is simple to master. If done correctly, an investor can earn a high return without taking on a lot of risk. However, carry trades do come with some risk. The chances of loss are great if you do not understand how, why, and when carry trades work best.


How Do Carry Trades Work?


The way a carry trade works is to buy a currency that offers a high interest rate while selling a currency that offers a low interest rate. Carry trades are profitable because an investor is able to earn the difference in interest—or spread—between the two currencies.

An example: Assume that the United States dollar offers an interest rate of 5.25%, while the Japanese Yen offers an interest rate of 0.25%. To execute the carry trade, an investor buys the United States dollar and sells the Japanese Yen. In doing so, he or she can earn a profit of 5.00% (5.25% in interest earned minus 0.25% in interest paid), as long as the exchange rate between United States dollar and Japanese Yen do not change.

To illustrate, here is how an investor would actually execute the carry trade:


Diagram 1: Executing the Carry Trade.


Buy USD/ Sell JPY

-Long USD position: investor earns 5.25%
-Short JPY position: investor pays 0.25%

- With spot rate held constant, profit is 5.00%, or 500 basis points




To summarize: A carry trade works by buying a currency that offers a high interest rate while selling a currency that offers a low interest rate.

So what do I need to do, to be able to earn this interest?

[The FX Power Course Staff]

Originally Posted by Student

So what do I need to do, to be able to earn this interest?

Good question. All you'd need to do is set up your account to earn interest. If you already have a live account, you can change this at www.myfxcm.com. If you're establishing a new account you can request it on your application. Then when you buy the higher interest country and hold it past 5pm EST, you earn interest daily on that position for as long as you hold it (including weekends). It's pretty amazing. Sometimes this can amount to hundreds of dollars per month in interest just trading one standard lot.

[Student]

Originally Posted by The FX Power Course Staff

Glad you asked. One easy place to find this is on www.dailyfx.com's home page. In the lower, left side. I've provided a screen shot of it below. Notice USD is 5.25% and JPY is currently .25%. In this case, we'd want to buy the USD/JPY pair and that would be holding the interest bearing side of the trade.

If I buy a pair that is more than likely going to be raising rates and I use a small number of lots (in theory) shouldn't that trade eventually go in my favor?

[The FX Power Course Staff]

Originally Posted by Student

If I buy a pair that is more than likely going to be raising rates and I use a small number of lots (in theory) shouldn't that trade eventually go in my favor?

Excellent question. In general when you have interest rate differentials between two countries rising, it eventually causes the higher yielding currency to rise. For instance, take a look at the chart below. The Fed was raising rates steadily on the USD and at the time JPY was holding at 0%. This rate differential was expanding in the favor of the USD. Take a look and see the trend that came about. Also note it weakened when there was talk of the rate hikes stopping in the U.S. and Japan starting to raise rates.

[Student]

Originally Posted by The FX Power Course Staff

Excellent question. In general when you have interest rate differentials between two countries rising, it eventually causes the higher yielding currency to rise. For instance, take a look at the chart below. The Fed was raising rates steadily on the USD and at the time JPY was holding at 0%. This rate differential was expanding in the favor of the USD. Take a look and see the trend that came about. Also note it weakened when there was talk of the rate hikes stopping in the U.S. and Japan starting to raise rates.

Hi, please tell me how I can find out what the interest rates are on each country so I'll know which to buy

[The FX Power Course Staff]

Originally Posted by Student

Hi, please tell me how I can find out what the interest rates are on each country so I'll know which to buy

Glad you asked. One easy place to find this is on www.dailyfx.com's home page. In the lower, left side. I've provided a screen shot of it below. Notice USD is 5.25% and JPY is currently .25%. In this case, we'd want to buy the USD/JPY pair and that would be holding the interest bearing side of the trade.