Trading Strategies

The currency carry trade: trading interest rates

Tammy Da Costa, CFTe®
2023-12-22
- Trading
- Education

The currency carry trade is a popular financial strategy, especially in times of aggressive interest rate adjustments by central banks. This strategy involves leveraging interest rate differentials between two currencies for potential profit.

A “positive carry” is realised when the profit earned on the interest rate received exceeds the cost of borrowing capital from banks.

Interest paid < Interest received

In this article, the following talking points will be discussed:

What is the carry trade?
Factors influencing the carry trade
The relationship between interest and exchange rates

What is the carry trade?

Imagine a scenario where borrowing money costs you almost nothing, and investing it elsewhere yields considerable returns. This is the essence of the currency carry trade, a strategy that can be as lucrative as it is risky.

When a trader engages in a carry trade, they typically borrow in a currency with a low-interest rate and invest in a currency with a higher interest rate.

For example, the Bank of Japan (BoJ) has set interest rates at -0.1% and in the United States, the Federal Reserve has set rates at 5.5%.

In this case, JPY would be borrowed to invest in USD.

Interest rates for the United States (blue) and Japan (orange)

Trading View Chart
Source: TradingView

Core components of the carry trade strategy

At the heart of the strategy is the funding and the target currency.

Funding currency: This is the lower yield currency that provides the capital for the trade.
Target currency: The target currency is the higher yielding currency which offers a higher rate of return for deposits.

Explore the different types of interest rates

Understanding the carry trade

Let's see how the carry trade would work if an investor borrowed money from a bank in Japan to invest the funds in a US bank account.

Step 1: Identify the funding currency and how much to borrow: An investor borrows Japanese yen (JPY) where the interest rate is very low (- 0.1% in our example).
For USD/JPY, the Japanese yen would be the funding currency and the US dollar would be the target currency.
Step 2: Use the borrowed funds to purchase the target currency: Funds are then converted into US dollars, either by trading the USD/JPY currency pair or by exchanging JPY for USD.
In the foreign exchange (Forex) market, one standard contract represents 100,000 of the first currency (USD), denominated in the second currency (JPY).
If ¥148.00 is required for $1, then ¥14,800,000 would be needed for $100,000 (100K x 148).
Step 3: Funds are invested in the United States: The $100,000 received during the exchange is then invested in a financial instrument in the United States, such as a government bond or a savings account, which yields a higher interest rate (5.5% in our example).
Step 4: Calculating the “positive” or “negative” carry: In our example, the potential profit from this carry trade would be the difference between the returns on the US assets (+5.5%) and the cost of borrowing in Japan (-0.1%), minus any transaction costs or exchange rate fluctuations.

Forex with a Broker you can trust

70 different currency pairs including major, minor and exotics - you’ll always have good options to choose from.

Interest Income or Expense: The trader earns interest on the USD held and pays interest on the JPY borrowed. The net interest is either credited or debited from their account, depending on the direction of the interest rate differential.

However, due to the -0.1% interest rate in Japan, interest is earned on both sides.

From the ¥14,8 million borrowed in Japan, the investor earns ¥148,000 (-14.8 M x - 01%) or $100.
On the $100K invested in the US financial system, the interest earned from the investment generates an additional profit of $5,500 ($100k x 5.5%).
In this case the gross profit from the interest rate differentials (before deductions) would be around 5.6%

This simplified example illustrates the basic mechanics of a carry trade using the interest rate differentials between the United States and Japan.

Factors influencing the carry trade

The carry trade is appealing when the interest rate differential is significant and the exchange rate is stable or moving in favour of the trade.

However, it's crucial to consider the risks, especially those associated with exchange rate volatility and possible shifts in interest rates.

1. Central Bank Policies: Both the Federal Reserve (U.S central bank) and the Bank of Japan (BoJ) set interest rates that directly affect USD/JPY carry trades.

USD/JPY monthly chart

With the US Federal Reserve raising interest rates aggressively from 0.25% during the Covid-19 pandemic (2020) to the current 5.5% (December 2023), the US dollar has appreciated against the Japanese yen, pushing USD/JPY to its highest levels in 40 years.

Capitalise on volatility in Forex markets

Take a position on moving Forex prices. Never miss an opportunity.

Chart prepared on TradingView

Policy Changes: If the Federal Reserve raises interest rates while the BoJ keeps rates low, the carry trade becomes more attractive, as the interest rate differential increases. Conversely, if the BoJ raises rates or the Federal Reserve lowers them, the trade becomes less profitable.

If a long USD/JPY position was opened in 2021 when the pair was trading around the 100.00 mark, this strategy could have delivered handsome profits over the past two years.

2. Interest rate differentials: If a trader was trading one standard USD/JPY CFD contract with Skilling, the following interest rate differentials need to be taken into account:

End of Day Adjustment: If the trader holds this position overnight, there will be a rollover. The broker recalculates the position's value based on the interest rate differential between the U.S. dollar and the Japanese yen.

3. Exchange rate fluctuations: The carry trade is highly sensitive to changes in exchange rates.

If the yen strengthens against the dollar during the investment period, the investor could face losses when converting USD back to JPY to repay the loan.

For example, if the investor borrowed 14.8 million JPY, converted it to USD, and then the JPY appreciated against the USD, driving the USD/JPY exchange rate to 144.00 it would take more USD (approximately $3,000 more) to buy back the same amount of JPY to repay the loan.

4. Global economic conditions: The overall health of the global economy can influence the carry trade. In stable economic times, carry trades tend to be more popular, as investors seek out higher yields. In times of economic uncertainty or crisis, investors may retreat from carry trades due to increased risk.

Crafting a strategy amidst volatility: The art of adaptation

Successful carry traders don’t just understand the market; they anticipate and adapt to its ever-changing nature.

This involves continuously monitoring interest rates, central bank policies, and global economic conditions to make informed, agile decisions.

Conclusion: The Intricacies and Excitement of Carry Trades

In conclusion, the currency carry trade is a complex yet thrilling strategy, offering the allure of profits through the savvy exploitation of global interest rate differentials. It's a strategy that demands not only a deep understanding of economic factors like central bank policies and exchange rate dynamics but also a keen sense of timing and risk management. For those who master it, the currency carry trade can be a gateway to significant financial rewards in the dynamic world of international finance.

Past performance does not guarantee or predict future performance. This article is offered for general information and does not constitute investment advice. Please be informed that currently, Skilling is only offering CFDs.