Yet this worthy strategy is often overlooked in favor of ones that might deliver quick profits. Interest rates are one of the biggest drivers behind currency movements. And one of the main reasons for this is the standard bank forex trading demo trade. Put simply, carry trading is a strategy for profiting from the difference in interest rates between two currencies.
Works To properly understand the carry trade, we first need to look at what’s actually going on when a trade is executed in the spot forex market. The spot market simply means for immediate delivery as opposed to delivery on a future date. When you enter into a trade, you in effect buy one currency and sell another for a given contract size, at the current exchange rate. However, as most forex trading is speculative and done with borrowed money, it’s more appropriate to think of one currency being borrowed, and the other lent. Just like when you go to a high street bank, when you borrow or lend money, interest payments are due. The basic aim of the carry trade is to borrow a currency with a low interest, and lend a currency with a higher interest.
This results in a positive interest rate flow. Carry trading has the potential to generate cash flow over the long term. This ebook explains step by step how to create your own carry trading strategy. It explains the basics to advanced concepts such as hedging and arbitrage. This strategy can be very rewarding because interest is paid on the full amount of the contract.
Since most forex traders use leverage, the carry trade can offer a substantial income yield. Let’s assume for this example that the base interest rate of the Australian Dollar is 2. While the base rate of Japanese Yen is 0. This means there’s a gross interest rate difference of 2. JPY, what we are doing in effect is borrowing Yen, and lending Australian dollars.
9,250,000 at an interest rate of 0. 100,000 at a rate of 2. 1 is the rate before the swap spread is applied. Below I explain how this is calculated. Notice that after applying the spread, the net interest paid on the short side is much higher than that gained on the long side.
04 from the lent Australian Dollars. 08 from the borrowed Japanese Yen. We must pay interest on the AUD, and we receive interest on the JPY deposit. But, the small credit interest on the Yen deposit becomes negative once the spread is included.
It’s important to note, these amounts are fixed overnight. JPY position of size one standard lot. The table shows what would happen if this trade were opened at the beginning of 2004, and held for ten years. Table 2: Long term returns in a 10-year carry trade. In this case, the payment stream from the carry interest more than compensates for the drawdown of the trade.
Not a bad return at all when compared to other investments over the same time period. If you’re planning on using a carry trade strategy, the first step is to find the most profitable combination of broker vs. Charges vary enormously among brokers, and across different currencies. So it’s essential to check that your planned trade actually offers the best risk adjusted return.
Don’t assume that carry trading will be profitable in every case. It might look that way at first glance. With some brokers, the interest spreads are so wide that they can make carry trades unviable. Table 3: Most profitable carry trade opportunities. When setting up a carry trade, interest yield isn’t the only aspect to consider.