Niels Bohr, the famous Danish physicist, once joked that “prediction is very difficult, especially about the future.” No words could better express the difficulties associated with exchange rate forecasting. As anyone involved in the business of currency forecasting can attest, it can be a humbling experience.
‘Having endeavoured to forecast exchange rates for more than half a century, I have understandably developed significant humility about my ability in this area.’ said Alan Greenspan, former U.S. Federal Reserve chairman.
Some may think writing about the fortunes of the stock market is tricky, but try to observe currencies. That’s the challenge.
A carry trade is a strategy in which an investor borrows money at a low interest rate in order to invest in an asset that is likely to provide a higher return. This strategy is very common in the foreign exchange market.
This strategy relies on relative stability in asset prices, as an adverse exchange rate movement can easily wipe out the returns from the underlying interest rate differential. This leads some to refer to the carry trade as akin to picking up pennies in front of a steamroller.
The aim of this strategy is to make profit from the interest rate differential. Sometimes the difference between the rates can be substantial and also adding leverage can really multiply profits. In currency trading a carry trade is a strategy in which a low-yielding currency (one with a low interest rate) is sold and the funds raised are used to purchase a high-yielding currency. The purpose of this type of trade is to profit on the interest rate differential of the two currencies. Leverage is commonly used to dramatically increase the profits earned through carry trades.
For example, in the period up to 2007 many investors borrowed in Japanese yen or Swiss francs, taking advantage of very low interest rates in Japan and Switzerland, and used the money to take long positions in currencies backed by high interest rates, such as the Australian and New Zealand dollars and South African rand.
BTW, Japan has kept low interest rates for quite a long time now. Australia and New Zealand have one of the highest interest rates in the developed world! In 2011 interest rates in Australia were as high as 4.5 percent!
Economists have developed a wide range of theories to explain how exchange rates are determined. Most studies conclude that for short- and medium-term horizons, up to perhaps a few years, a random walk characterises exchange rate movements better than most fundamentals- based exchange rate models. Most studies find that models that work well in one period fail in others. Most studies also find that models that work for one set of exchange rates fail to work for others.
An strategy that has attracted a lot of interest among international investors is the so- called foreign exchange (FX) carry trade. FX carry trades entail going long a basket of high- yielding currencies and simultaneously going short a basket of low-yielding currencies. Although the empirical evidence suggests that the excess returns on this strategy have been fairly attractive, investors need to be mindful that carry trades are prone to crash when market conditions become volatile. Hence, investors need to overlay simple carry trade strategies with well- thought- out risk management systems to help protect against downside risks.
How carry trading works in Forex?
Let’s assume that you went long on AUDJPY and kept the position open overnight until the next day. Essentially you are buying AUD and selling JPY.
What happens the next day is that your forex broker will either debit or credit you the overnight interest rate difference between the two currencies. This rolling over of your position is known as the carry trade.
If the interest rate earned on AUD is 4.00 percent and JPY is 0.10 percent, your profit from the interest rate differential is 3.9 percent per year! This is considered a positive carry trade. A negative carry trade happens when you buy JPY and sell AUD, meaning you would end up with a negative interest rate differential.
This example is based on 1:1 leverage and assumes exchange rates remain constant for the whole year. Try to imagine applying leverage. In the example above, if you had a leverage of 100:1, your return would now be 100 x 3.9% = 390% on just the interest rate differential!
When are carry trades successful?
We are still on example of AUDJPY. If the central bank in Australia were to raise interest rates, then you would make even more gains. Therefore, you have to be mindful of the economic conditions in Australia. If the Reserve Bank of Australia is optimistic about the economy, then they will likely raise rates.
But, if the economy is slow and the RBA believes it needs to lower rates to stimulate the economy, then the AUDJPY as a carry trade would not be that successful. Meanwhile, if the AUDJPY exchange rate moved higher, in addition to higher interest rates, your long position on the pair would gain even more!
The principle of “uncovered interest rate parity” says that the exchange rate of any two currencies should adjust to eliminate any possibility of making a real profit from an interest rate differential. Similarly, the Law of One Price says that the real carry cost of an asset should be the same in every country. In practice, carry trades can be extremely persistent. Because the FX component of a cross-currency carry trade involves selling the low-interest-rate currency and buying the high-interest-rate one, the carry trade itself tends to make the exchange rate of the low-interest-rate currency fall relative to the other. If carry trades are sufficiently large in volume they can cancel out any tendency for exchange rates to equalise, enabling profits to be made over long periods of time.
This lead us to believe that carry trades work best when risk aversion is low and investors are willing to invest in high yielding (risk) currencies.
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