Forex carry trade involves the entering of positions in positive interest/carry/yield paying currency pairs.
This is done to profit from interest receipt and possibly the capital appreciation in such pairs as investors flock to such trades. In short, you will want to ‘borrow’ or short a low interest rate currency while ‘deposit’ or long a high interest rate currency.
For example, a consistently popular pair is AUD/JPY.
Currently, AUD interest rate is 2.5% p.a. while JPY interest rate is 0.1% p.a.
When you go long AUD/JPY, you will be borrowing JPY at 0.1%, exchange them into AUD and then buying AUD bonds that pays you 2.5%, netting you 2.4% a year. Coupled with leverage of 50 to 100 times and you will be making a potential 120% or 240% a year on your account funds!
Now, there are a couple of problems with carry trading for the retail investors.
Interest rate spread
Most brokers calculate and pay interests daily with a cutoff time at 1700 (5pm) New York time. An example is FXCM.
The second type of brokers pays interests by the day or even by the seconds. An example is Oanda.
Referring to the above AUD/JPY example, you will not be getting 2.4% on your position as there is also an interest rate ‘spread’.
As you can see above there is a spread for interest rate payment or receipt. For example, FXCM pays you 0.41 USD per 10k lot size in AUD/JPY or 4.10 USD per 100k for each day you keep your trade open.
Let’s do some Math!!!
We will go long or buy 100,000 AUD/JPY.
5.02 x 365 = 1,832.30 USD p.a. in interest (Oanda actually paid out more.)
4.10 x 365 = 1,496.5 USD p.a. in interest (FXCM)
These are estimated numbers and changes throughout the year. But it provides a good guide.
FXCM has a weird way of calculating required margin but we shall just follow them to calculate our return in this case. A 100k long AUD/JPY trade requires 2,400 USD in margin, although the value of this trade is 100k AUD (which is 90,190 USD in value).
So our interest return is actually only 1.659 % (1496.5 returns on 90190). However, with leverage, you are required to come up with only 2,400 USD for this, giving you a 62.35 % return! (1496.5 returns on 2400) Amazing for now but there is more.
We were assuming AUD/JPY maintains its exchange rate for the full year but that is hardly logical. In fact, AUD/JPY’s yearly price range is about 1,600 pips for the past 3 years and has a monthly range of about 600 pips. (just pull a 12 ATR indicator onto AUD/JPY monthly chart).
What that means is you may need to put aside about 15,000 USD to weather most or all possible drawdowns and keep your position open. So add that to the 2,400 USD margin and you will only be getting a 8.6 % return on your money. (1496.5 on 17400) Nothing to write home about and you still have to worry about capital depreciation.
If AUD/JPY falls by 150 pips or more from your entry point, all your interest income are gone! Of course, you may also enjoy a boost if AUD/JPY goes up, which does happen most of the time. And with that, comes the carry trade cycle and unwinding.
Carry trade cycle and unwinding
Not just retail forex traders, but ordinary currency and foreign deposits investors, hedge funds and banks are also after the interest return. So in the larger financial landscape, money is indeed flowing from low interest currencies to high interest ones using instruments like bonds and treasury bills.
Therefore, there is actually a long bias to such carry yielding pairs and there is a trend most of the time.
As more and more money bet in the same direction, there is often fallout. Simply put, there will always come a point where there are no longer enough money to keep the trade afloat and traders start to cash out.
As a result, margin calls and stops are triggered and you see everyone trying to get out at the same time and price crash big time. 1992, 1997 and 2008 are the 3 most recent massive ones for the AUD/JPY pair. It has happened before and it will happen again.
How AUDJPY carry trade performed
Looking at the above data, interest income is insignificant compared to the gyrations in exchange rate which has much more impact on your profitability.
For example, we will invest at the start of 2007, buying AUDJPY at 94.24. At the end of 2012, after 6 years, the price closed at 89.88 in December. You would have gained about 23.55% interest return, while making a loss of 4.63% in capital depreciation. In the meantime, you would have endured an incredible 41.57% drawdown in 2008 when price dropped to 55.06.
Assuming we invested 2400 USD for the margin requirements and a further 40000 USD to survive the max drawdown period. Our effective leverage will be in the region of about 2 times only. This would boost our potential interest income to about 47% over the 6 years or about 8% per annum.
Forex carry trade may not be as good a strategy for retail traders but you can still make some profits out of this knowledge. Even though you may not be able to benefit directly from the interest income, you already know there is a long bias on currencies that pays better. Often times, a trend will develop. Just be sure you have your stop loss in and plan in advance, when, how and where you will exit your positions.by