Introduction to Currency Carry Trade and Rollover

The currency carry trade is a popular trading strategy in the foreign exchange (forex) market. It involves borrowing a low-yielding currency and using the proceeds to purchase a higher-yielding currency. The primary aim of this strategy is to take advantage of the interest rate differential between the two currencies. This interest rate differential, also known as the “rollover,” forms an integral part of the carry trade strategy. Traders are attracted to carry trades because they can potentially earn daily interest payments in addition to any currency appreciation resulting from the trade. In this article, we will explain in detail how the currency carry trade works and present a top carry trade strategy to use in your own trading.

What is a Currency Carry Trade and How Does it Work?

To understand the currency carry trade, let’s look at the mechanics behind it. This strategy involves borrowing a currency in a country with a low interest rate (low yield) and using the borrowed funds to purchase a currency from a country with a high interest rate (high yield). By holding this position overnight, the trader receives an interest payment based on the “positive carry” associated with the trade. The lower-yielding currency is referred to as the “funding currency,” while the higher-yielding currency is known as the “target currency.” This interest payment, or rollover, is credited or debited to the trader’s account depending on the direction of the trade (long or short) and the positive or negative interest rate differential. It’s important to note that these adjustments are made at the daily adjusted rate, as interest rates are quoted on an annual basis.

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Currency carry trade infographic

Interest Rates

Interest rates play a crucial role in the currency carry trade. They are determined by a country’s central bank as part of its monetary policy. Interest rates can vary significantly from one country to another. Traders can earn interest on a position when they hold a long position in the currency pair with the higher interest rate. For instance, if the Australian dollar offers an interest rate of 4% and the Japanese Yen has an interest rate of 0%, traders may choose to buy (go long) the AUD/JPY pair to benefit from the 4% net interest rate differential.

Changes in Interest Rates

The primary component of the carry trade strategy centers around changes in interest rates. Even if the exchange rate between the two currencies remains unchanged, traders can still profit from the overnight interest payment. However, it’s important to acknowledge that central banks often adjust interest rates over time, which poses a potential risk to the carry trade strategy. Changes in interest rates can impact the profitability of the trade and require traders to closely monitor and react accordingly.

Exchange Rate Appreciation/Depreciation

Apart from interest rate differentials, exchange rate movements also play a significant role in the carry trade strategy. Traders aim for the target currency to appreciate (increase in value) when they hold a long position. When this happens, the trader benefits from the daily interest payment as well as any unrealized profit from the currency’s appreciation. However, the trader will only realize these profits when they close the trade. It’s important to note that if the target currency depreciates against the funding currency, traders may incur losses that could wipe out the positive interest payments.

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FX carry trade example using AUD/JPY

A Currency Carry Trade Example

To illustrate the currency carry trade strategy, let’s consider an example. Suppose the current Australian Official Cash Rate stands at 4%, while the Japanese Yen yields 0%. In this scenario, a trader might decide to take a long trade on the AUD/JPY pair if they believe the pair is likely to rise. Traders looking to capitalize on the interest rate differential borrow Yen at the lower rate and receive the higher interest rate associated with the Australian dollar. However, it’s important to note that retail traders typically receive slightly less than the advertised interest rate due to spreads applied by forex brokers. For a detailed example of how to calculate the approximate overnight interest charge/gain, you can refer to our article on understanding foreign exchange rollover.

The Risks Involved with Carry Trades

As with any trading strategy, the currency carry trade comes with certain risks that traders need to be aware of and manage effectively. Here are two primary risks associated with carry trades:

  • Exchange Rate Risk: If the target currency weakens against the funding currency, traders holding long positions will see the trade move against them. However, they will still receive the daily interest payments.
  • Interest Rate Risk: When the country of the target currency reduces interest rates while the country of the funding currency increases interest rates, the positive net interest rate decreases. This can reduce the profitability of the carry trade strategy.

FX Carry Trade Strategy

To enhance the effectiveness of carry trades, top traders often employ strategies that filter trades in the direction of the prevailing trend. Since carry trades are typically long-term trades, analyzing markets with strong trends can improve the probability of success. Traders should first confirm the presence of an uptrend before entering a trade. This can be done by identifying higher highs and higher lows on the price chart. A break of the horizontal line drawn at the first higher high confirms the uptrend. Traders can then utilize multiple time frame analysis and technical indicators to identify ideal entry points for long trades.

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Trend bias in positive carry trade strategy

Conclusion

Currency carry trades offer traders opportunities to profit from both exchange rate differentials and interest rate differentials. However, it’s crucial to manage risks effectively. Losses can occur if the currency pair moves against traders or if the interest rate differential narrows. Implementing risk management techniques and seeking entry points in the direction of an uptrend are essential for higher probability trades. To improve your forex trading strategy and enhance your understanding of carry trades, you can leverage various resources and guides available. Identifying trends and staying updated with market analysis can further strengthen your trading skills.