Carry Trade: What is the return on your Investment?

By September 2, 2014 Trading 3 Comments
Carry Trade: What is the return on your Investment?

A carry is generally classified as the difference between the cost of funding an asset and the return different derived from it. Needless to say, it may not always be positive. For there could be situations where the profits generated by a company may not be more or equal to the cost of funds, thereby generating a loss and incurring a negative carry.

Share trader should know the return on investment

Carry trades, though same in principle, are however not viewed in terms of business generating profits. They are looked at more globally in terms of various currencies and the borrowing / lending interest rates that these currencies offer. It is a termed a currency Carry Trade. Carry trades are available in commodities as well, copper carry trade being most popular, but the underlying theme of carry trades in the financial world arises from the interest rate differential between several countries.

Currency Carry Trade:

A text book definition of a (Currency) Carry Trade will be: A phenomenon where you borrow a currency that commands a low interest rate (borrowing cost) in the market and invest in a currency that offers a high interest rate (Lending rate).

A simple example of the same being: Borrow JPY @0.1% p.a. and invest in AUD @ 3.75% p.a., thereby enjoying a carry of 3.74% (Ceteris Paribus). For the Indian audience – You can think of it as borrowing US dollars @ Libor (0.44%), converting the USD into INR and investing the INR in the call money market (approx.. 8% p.a.), thereby enjoying a good carry.

Now for all those who wonder about how do we go about borrowing and investing in these currencies from your home, all you have to is sell JPY/AUD or buy AUD/JPY in the spot market on your broker provided market platform. FXCM is one of the most popular platforms for currency trading in the spot market. This will automatically do the needful and you will net the interest rate differential in terms of rollover gains every day.

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Is it that easy?

Wow, it seems like a cakewalk, doesn’t it!! All you have to do, is find out which two countries have the highest interest rate differential, open an account with FXCM, sell/buy the currency pair depending on where the carry is, negotiate the leverage terms with your broker to amplify your returns, book a  world tour and let the returns from the carry trade fund your leisurely expenses.

Now let’s get you out of that dream. In a couple of paragraphs above, where I had given the example of the AUD/ JPY 3.74%  carry trade,  two magic words namely Ceteris Paribus were mentioned. This is a latin phrase that means “All other things being constant”. We all know the dynamic world of currencies (Mexican currency crises, Southeast currency crises etc.), where the basic assumption of anything being constant is a sure shot road to hooverville.

A carry trade as we just saw involves shorting a currency and buying another. This is what you do when you go long (short) a currency pair – You go long (short) one currency and short (long) the other. So inherently, your trade faces a big risk of that currency pair going against you. Carry on with the AUD/JPY example: When you borrow / short JPY, you create a liability. Simultaneously when you invest in/ lend / long AUD you are creating an asset.

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Now three situations can arise:  

AUD/JPY doesn’t move much over our trading Horizon à You pocket the carry and everything is fine.

AUD/JPY starts moving up i.e. AUD(Asset) appreciates / JPY(Liability depreciates) à Bonanza à You pocket the carry as well as the price gain

AUD/JPY starts moving down i.e. AUD(Asset) depreciates / JPY(Liability appreciates) à You pocket the carry but lose out on the price front.

Looking at the above scenarios, it doesn’t look a bad bet since you will only loose in one of three situations and that too has a cushion of the carry.

However, this requires a deeper study.

1) If you look at the interest rate differentials ( so called carry), their nominal value is not  that high to entice so many investors into taking that sort of a risk. What makes it luring and equally risky then, is the leverage (mentioned earlier). A 10:1 leverage enjoyed through your broker can help you amplify the 3.74% p.a carry into a 37.4% p.a return. However this leverage will also amplify the gains and losses that you incur on the price, thus making this trade a risky proposition.

2) Countries that offer high interest rates, generally undergo high levels of inflation, some sort of deficits, have low to mid level of FX reserves and are more emerging in nature. This makes them more volatile to global and domestic shocks thereby making their currency a risky asset. Classic example are the Indian Rupee, Brazilian Real etc.

Thus, the most imperative step in the carry trade process becomes the currency pair selection.

So let us conclude by looking at some of the characteristics that we will like to see while choosing a currency pair and the market environment where we would like to play this strategy.

The article will end with a GBP/JPY carry trade example taken from FXwordpress. This will substantiate the importance of the carry in the overall returns obtained in the trade.

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Terminology:

Currency that you borrow or sell (on your platform): This is the funding currency.

Currency that you invest in or buy (on your platform): This is the investing currency.

Characteristics of a funding currency:

1) Low interest rates

2) Dovish outlook of interest rates / QE in the pipeline – Depreciating effect on that currency

3) Negative data primers such as PMI, unemployment, deflation – Something that can force the central bank to provide for an accommodative/easing/expansionary monetary policy.

Characteristics of the investing currency:

1) High interest rates

2) Hawkish outlook of interest rates

3) Positive data primers such as PMI, employment, inflation etc – Something that can force the central bank to provide for tightening monetary policy.

Characteristics of the global environment:

1) High risk appetite – This is measured by the VIX index. Low levels of VIX indicate risk on. Also booming stock markets is an indicator of risk on attitude. On the other hand, rising Treasury bond prices, CDS spreads and safe haven commodity gold predict risk averse nature.

2) Confidence in economic recovery.

In General, Safe haven currencies are USD, JPY, CHF and the Risk Currencies: Euro, GBP, AUD, NZD, emerging market currencies.

GBP/JPY carry Trade: 

GBP/JPY carry Trade GBP/JPY carry Trade

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