Before we talk about what a currency carry trade is in forex, it would be useful to define carry. It’s the cost or income from owning an asset. For example, commodities often negatively carry assets because they may depreciate and cost money to store. Positive carry assets include financial instruments such as bonds. As you hold them, they pay an income.
Now let’s take a look at carry trading from the perspective of forex trading. Carry trades in forex exist because of a basic mechanism in forex trading. The terms for this mechanism are rollover, swap, or financing fees. Rollover is often the most common name, but they all mean the same thing. It automatically occurs for all forex positions; traders do not specify that they want to carry trade. Forex positions either earn you income or cost a fee for holding them overnight.
When it comes to the forex market, overnight means after 5:00 PM Eastern Standard Time. This is when the rollover is calculated. It always turns into an overnight rollover, even if the position was opened shortly before 5:00 PM.
Rollover in Carry Trading
The last step in understanding forex carry trading comes in knowing how to calculate the rollover. The rollover is based on comparing the interest rates of the two currencies in the forex pair.
As a simple example, imagine the American overnight interest rate is 2.5%, and the Canadian overnight interest rate is 1.5%. It’s the central banks of the country that determine these rates. Entering into a position in the USDCAD forex pair and holding it overnight (past 5:00 PM) would create a rollover. If this was a long position in USDCAD, the rollover would be [USD interest rate – CAD interest rate]. Here that would mean 2.5% – 1.5% = 1% of rollover earnings. A sell position in USDCAD would be the inverse, 1.5% – 2.5% = 1% of rollover fees.
This 1% fee or earnings from the rollover is even smaller than it might appear. We express these interest rates in per annum terms. That roughly translates to 1% interest per year. For this reason, we then divide the 1% rollover by 365 to change the rate to daily. So far, this sounds insignificant.
The last key component is that forex trading is typically done with large leverage, up to 50 to 1 in the USA. This means that if you have $1,000 in your account and 50:1 leverage, you can take a forex position of up to $50,000.
The leverage multiplier matters a lot when it comes to rollovers. It allows traders to have much larger positions, which goes hand in hand with larger rollovers. Another facet that helps carry trading is the ability to choose the forex pair of the trade. We showed a 1% difference in the example above, but this rate could be much larger. Though they are not usually together in a forex pair, take the Swiss franc at an interest rate of negative 0.75% and Argentinian peso at 40%. They create a much larger 40.75% interest rate per year or about 0.11% per day on a position. For a position of $100,000 ($2,000 account at 50:1), the rollover would be $111 per day.
There are pitfalls to using this strategy as well. The most important one to consider is that the trade itself could be a loss. Carry trades are more successful in stable currencies, but there is always the possibility of danger. When you find a currency with a good enough interest rate to be used in carry trades, there are probably many other traders thinking the same thing.
This is a problem because everyone will want to close their positions if the exchange rate starts moving against the currency bought in favor of the sold currency. As everyone sells the currency, the price gets even worse, and there are liquidity concerns.
Carry Trading During the 2008 Crisis
Carry trading has been noted to cause disruptive issues of this nature. One example was the appreciation of the Japanese yen around the time of the subprime mortgage bubble. In 2007 the exchange rate was 124.176 yen for one USD. By the end of 2008, it had slipped far to 90.612, meaning the yen was much stronger than the USD. The Japanese yen is a typical currency for carry trades due to its stability and policy of keeping the value low.
The US economy had issues starting in 2008 due to the subprime bubble. The Federal Reserve had two key reactions to this: credit easing and lowered interest rates. Credit easing is a process where the Fed buys debt to inject money into the economy. This injection reduces the value of the dollar. Combined with the lower interest rates, this suddenly made carry trades far less attractive.
For these reasons, fewer carry trades were taken on after the subprime crisis began. Even more significant is that everyone exited their carry trades, meaning they bought yen. This only gave more fuel to the fire by adding an influx of yen buyers, further increasing its value. This was far less than ideal for both the US and Japanese economies at that time. By late 2011 the exchange rate had moved all the way to 75.56, meaning a much stronger yen relative to USD.
Carry trades are an important facet of Forex trading that can strongly influence currencies. Use them carefully and watch out for moments where they might change the game.