Forex Trades: Carry Trading Strategies in Forex
A carry trade is a strategy adopted by traders in which a trader borrows at a low interest rate and invests in an asset which yields a higher rate of return. But what many investors do not know is that this strategy can be adopted with currencies as the assets.
More specifically, a forex trader needs to borrow a currency at a low interest rate, convert it to a valuable currency and then “lend” the converted currency to the market at a higher interest rate. This is done using a forex trading account from a reputable broker.
Forex Carry Trade Example
Let’s look at a hypothetical carry trading example where, for instance, a trader were to borrow 100 X (where x is a currency) at an interest rate of 0.01% and then convert this to 1 Y ( where 100 X = 1 Y and Y is a currency). The forex trader can then lend this currency to the market at a rate of 0.31. After paying off the interest on borrowings, the trader makes a profit given the exchange rate remains constant. In this scenario, the trader owed 101 Japanese Yen but after converting the Australian Dollar back to Yen has made 131 Japanese Yen.
The risk the trader faces is the fluctuation in currency rates due to unforeseen events. To make significant profits, the investments of the trader must be larger. In the graphic above, a similar example is outlined using the USD/JPY currency pair.
Potential Trading Obstacles
Of course, no forex trading strategy is completely foolproof, and problems like the Asian currency crisis can create obstacles when using funding currencies like the Japanese Yen can occur. When a currency strengthens for whatever reason, the profit margins of the trader become slimmer.
If the other currency strengthens enough, forex traders run a risk of loss and there might be a need to cover the trade. To cover their trade, the fore trader will need to borrow more of the original currency to pay off the balance.
Demand for Carry Trade Currencies
As a lot of hedge funds tend to indulge in carry trades, a small fluctuation in the exchange rate will have many hedge fund trying to unwind their trade. This creates a reinforcing effect as it tends to increase the strength of the currency.
Forex Price Chart: AUD/JPY
This is because there is now a growing demand for the currency, and a greater need to close trades. This often results in a growing number of forex traders who may have made a small profit or broke even, and they will now look to scavenge for currencies opportunities to unwind their trade causing the available exchange rate.
This strategy became popular from 2000, where the AUD/JPY offered an average annual interest of 5.14%. The leverage of the market was as high as 200:1, the investors earn a healthy return even if the currency pair shows no appreciation. This carry trading forex strategy has become popular over the last two decades, where the AUD/JPY has offered an average annual interest of 5.14%. The leverage of the forex market is high at 200:1, so investors can earn a healthy return even if the currency pair shows no appreciation.