What is the carry trade in forex?

The carry trade in forex is one of the oldest forms of currency trading and investing. It’s a straightforward, longer-term position trading strategy predating online internet trading.

The carry trade in currency trading involves using the difference in central banks’ interest rates to profit from various currency movements. You use the low-interest rate bearing currency to buy a higher interest rate carrying currency.

Typically, currencies from countries with higher interest rates rise against those with lower rates. After all, investors prefer the higher rates on offer as potential safe-haven investments; if the timing is right and the interest rate is so attractive, the transaction and move into currencies carries less risk than, for example, equities. But there’s a caveat to this opportunity, most carry trade investors look for trades involving G7 currencies.

What is the carry trade?

Because a carry trade involves borrowing in a low-interest rate currency and converting the borrowed amount into another currency, the carry trade phenomenon isn’t limited to currency trading. It gets used to invest in any asset. However, it is still one of the most popular methods to invest in currencies, and institutional investors favour such strategies when hedging their clients’ exposure.

Traders and investors can apply the theory of the carry trade to buy and sell assets such as stocks, commodities, bonds, or real estate denominated in the second currency.

How Do Carry Trades Work?

Let’s use an example we can all understand to explain how the carry trade works in its simplest form.

Suppose you take a 0% interest rate cash advance of $10,000 offered by a credit card firm, typically the kind of offer marketed to new customers for a limited period, perhaps a year.

Now imagine using that cash advance (costing you no interest) to put in an asset that guarantees you 3%, like a bond. Over the year, you’ll generate $300 profit by way of the interest on your bond. So, once you pay back your interest-free advance, you’ll be left with your $300 gains.

Now, if you apply that phenomenon to forex and consider the power of leverage, you can quickly grasp that your 3% profit could become magnified many times over.

The basics of the forex carry trade

To ward off the effects of the Great Recession of 2008-2010, central banks adopted either ZIRP (zero interest rate policies) or NIRP (negative interest rate policies). Since this implementation, it has become increasingly challenging to engage in carry trade transactions.

Suppose the USA Federal Reserve lowers its primary interest rate to near zero, and the ECB, Bank of England and Bank of Japan have remarkably similar rates. In that case, it’s close on impossible to squeeze profit from the carry trade once you account for costs.

And forex carry trades only work if you have deep pockets. After all, you’re looking to make small percentage gains on the transaction over the long term. Because many banks have adopted ZIRP or NIRP policies, private investors and retail traders can sometimes struggle to justify any carry trade transactions unless they take risks on volatile currencies.

Forex carry trade examples

Let’s look at two examples using the primary the exotic pair USD/BRL and primary currency pair AUD/USD.

• USD/BRL as an exotic pair carry trade opportunity

Brazil’s current primary interest rate is 5.25%, while the USA rate is 0.25%. So, in theory, using US dollars to buy Brazilian reals makes sense. But on September 22, 2021, one USD bought 5.27 BRL, and over recent weeks USD has risen sharply versus BRL.

In fact, since the start of 2021 and year on year, the currency pair USD/BRL is close to flat, illustrating how tricky spotting carry opportunities can be, even when the interest rates between two countries are quite a distance apart.

As with all FX trades, timing is critical. Over the past twelve months, there have been weekly periods when the currency pair has traded in a wide range.

• AUD/USD as a primary carry trade opportunity

Australia’s current interest (cash) rate is 0.1%, a record low announced by the RBA central bank in November 2020 as a stimulus measure to counter the effect of Covid and various lockdowns.

The USA interest rate is 0.25%, and although this appears to be only a fractional difference compared to the Aus rate, the gap has partly helped create a carry trade opportunity since the turn of the year.

If you analyse a weekly time frame of AUD/USD, you see the currency pair rose strongly throughout March to November 2020. However, during 2021 as the rate cut took effect, the currency pair has given back a percentage of the gains.

The factors affecting the 2020 rise included AUD being a commodity currency linked to the price of oil; as the global economy began to thaw out of Covid restrictions, the cost of oil and other commodities such as copper spiked sharply upwards.

The USA Fed suggested in summer 2021 that monetary stimulus would get significantly reduced. Allied to the RBA rate cut, this bolstered the price of USD v AUD.

How do interest rates affect the carry trade?

Although some of the factors mentioned earlier, such as commodity prices, market sentiment, fiscal and monetary policy can affect the carry trade, the most influential criteria are central bank interest rates.

When you put on a carry trade, you are buying low and selling high. You buy the high yield currency with a low-interest yield currency with the possibility to sell the high yielding currency in the future at a profit.

There have been glaring opportunities in the recent past to profit from the carry trade. For instance, from 2000-2007, Japan’s rate was close to zero, while New Zealand and Australian rates hovered around 5%. So, AUD/JPY and NZD/JPY trades made sense.

However, as mentioned previously, since 2008, carry trade yield has been tricky to profit from in a coordinated central bank NIRP or ZIRP policy because the interest rate spreads don’t exist.

Sure, there’s a potential to squeeze out a profit if the Aus rate is 0.1% and the JPY rate is 0.00% or negative, but the spread is not wide enough to encourage a mass movement from one currency to the other.

Perhaps it’s a suitable time to move on to the subject of the risks associated with the carry trade.

The risks of the carry trade

• Timing is still everything
• Deep pockets are needed
• Leverage is key
• Your profit only gets realised once you transfer your money back into your domestic or base currency
• Carry trade opportunities mainly exist in exotic or minor currency pairs

Timing and strategy are still key

During times of very narrow interest rate spreads, you can’t rely on one G7 economy having 4% interest rates, another having 1% and profit from the difference by going long in the higher interest rate currency. You must still apply technical and fundamental analysis to get your timing right.

Deep pockets needed to profit

You can’t put a carry trade strategy in place with a $500 account. A 5% return, even allowing for the leverage bounce, won’t pay the bills. It would be best if you thought about the opportunity like a buy and hold equity investment strategy, so you’ll need a much bigger account, perhaps in the tens of thousands.

Leverage is critical

Without leverage, your risk v return on a carry trade position becomes unattractive. Unfortunately, European authorities have cut back on the leverage brokers can offer, and you’ll need more margin to put in place carry trade strategies.

When to take profit

You must constantly watch the interest rates of the two countries’ currencies and pay attention to any central bank or government policy announcements likely to affect the currency value. A sudden change in policy by a central bank can reduce your profit in an instant.

You’ll employ a position trading method, so the technical analysis may take a while to develop a strong signal for you to enter, to exit or modify your stop and limit order.

And remember, your profit doesn’t get realised until you have banked profit in your base or domestic currency.

Exotics and minors are where carry trade opportunities exist

As previously discussed, due to ZIRP and NIRP central bank policies trading exotic or minor pairs represents the most obvious opportunity to carry trade in the FX market. However, this comes with risk. Do you want to ‘own’ pesos, bolivars, rupees and reals?

The exotic pairs involve higher risk because the higher interest rates could relate to inflation being an issue in the country. High interest rates are, in theory, only attractive as carry trades if the economy is stable.

And suppose you trade Norway’s krone v USD, knowing the krone is a very stable currency in a well-functioning economy and society. In that case, you’ll pay a significant spread as you will with any of the exotics mentioned.

As you can see, despite the carry trade mechanics appearing simple to implement, the opportunity isn’t all about one country’s interest rate being high and another's low. As with all trading you need to apply yourself and understand the market to succeed.

Click on the button below to Download our "What is the carry trade in forex?" Guide in PDF