What is carry trade

Negative and Positive Carry Trade in Forex happen when a trader borrows one currency (e.g JPY) and use it to buy another currency (such as the USD)

To carry means to hold. 

With carry trade in forex, you can profit from a currency pair interest rate difference whether the currency appreciates or stays at the same price.

However you have to hold trade for a longtime.

What is carry trading

Carry trading means borrowing or selling a financial instrument with lower interest rate to buy another with higher interest rate. The profit is from their interest differentials.

As earlier said, carry trade in forex is, when a trader borrows one currency (for instance the JPY) and use it to buy another currency (such as the USD). The reverse is also true.

The lower interest rate currency is the “funding currency” while the currency with the higher interest rate is the “yield currency”.

In this case, the trader pays a low-interest rate on the borrowed/funding currency while collecting the return on the higher interest rate currency bought.

The difference is known as the interest rate differential.

Forex Carry trade has 2 main strategies.

1. positive Carry trade
2. Negative Carry trade

Positive Carry Trading

Positive carry trade in forex involves borrowing a currency with a low interest rate while buying a currency with a high interest rate.

In this case,

The trader is with an assumption that the higher interest rate currency will remain the same or appreciate.

 He therefore hopes to receive interest rate payments equal to; the interest rate differential between the two currencies in the pair and the size of their position.

When you sell a currency with low interest rate while buying another with a higher interest rate, you are paid interest for holding currency with a higher interest rate.

The Negative carry trade

Negative carry trade in forex involves borrowing a currency with a high interest rate while buying a currency with a low interest rate.

Here,

A trader enters a negative carry trade with an assumption that the lower interest currency will appreciate relative to the higher interest rate currency.

As a result, the trader incurs a loss on the interest rate differential. Therefore, will have to pay interest for holding that position.

On contrary,

If the higher interest rate currency depreciates relative to the lower interest rate currency, any losses made in a carry trade may be offset.

This could turn into a net gain.

Carry Trade Example

Let’s say you are holding a certificate of deposit with your bank amounting to $10,000 at an interest rate of 2% per year.

Later, you realize you can invest with New Zealand bank at a rate yielding 4% per year.

So, you sell off your certificate of deposit and invest in a higher yielding investment(New Zealand bank). By doing so, you have done carry trading.

Alternatively,

You can borrow money from the bank; let’s say $5000 at 2% interest.  Then lend it out to someone else at a higher interest for example 5%.

You will remain with 3% as your profit after paying back your debt of 2%.

Positive carry trade requires you to sell/ borrow financial instruments with low interest rates to finance/ purchase instruments with high interest rates.

This simply means that; as an investor or a trader, you will profit from the interest differentials.

The Forex Market example. 

If for instance, a trader buys USD/JPY.

If the USD rate is at 1.75%, and the Japanese Yen interest rate is at -0.1%, the trader will profit from 1.85% interest rate differential.

Interest rate differentials.

Subtract the lower interest rate from higher interest rate for the currencies in a pair.

The interest rate used is the one for the prevailing inter-bank deposit rates for the time during which the carry trade will be kept.

When you get a profit after taking the difference that will be a positive carry in forex whereas If the difference is a negative, it becomes a negative carry.

Conclusion

When it comes to carry trade in the currency market, I should say it is very popular especially to the big market makers.

These are the banks, hedge funds and big institutions.

Carry trade may not be such of a big deal to small independent traders.

This is because it requires one to hold a trade for a long time to profit from it.  Like 1 month to 1 year.

Therefore this is not common to short term traders though it is applicable.