As the echoes of the 2008 financial crisis still resonate, the world is now grappling with a new economic challenge: swift inflation. This inflation surge has brought the carry trade back into the limelight, a strategy that had faded away post the 2008 debacle. Carry trading has re-emerged as a potential avenue for forex enthusiasts. Let's delve into this technique, exploring its mechanisms, benefits, risks, and its place in the historical context.
Understanding Carry Trading
Carry trading, at its core, is a strategy where investors seek to profit from the difference in interest rates between two currencies. Instead of capitalizing on fluctuations in currency values, traders earn based on interest rate spreads. Imagine a Swede with a savings of 200,000 SEK (around US$19,200). With the interest rates offered by Sveriges Riksbank at 2.5% in November 2022, and retail banks giving even lesser, there’s not much to earn. Enter Hungarian banks with their alluring 13% interest rates. However, converting SEK to Hungarian forint poses currency exchange risks.
Modern traders can bypass this hurdle by utilizing derivatives, specifically contracts-for-difference (CFDs), to tap into lucrative interest rates in different countries.
Harnessing Derivatives for Carry Trading
CFDs stand out in the derivatives market for their non-expiry feature. This means traders can hold onto them for as long as they deem fit. But there's a catch: holding CFDs overnight means undergoing a tom-next trade, which involves adjusting positions through swaps. These swap rates are directly linked to the interest rate differences between currencies. Until recently, positive carry, where the interest earned exceeds interest paid, was a rare gem in the forex world.
Positive Carry Explained
A rollover at 17:00 New York time daily sees brokers either pay or collect swaps. When the swap is positive, traders stand to gain, and this opportunity is termed as a positive carry. Successful trades should ensure the positive swap outweighs any potential exchange rate losses.
Leverage: Amplifying Carry Trading
By leveraging, traders can enhance their potential profits from positive swaps. For instance, with a 1:20 leverage on a currency pair, a sizable position can be attained with a comparatively smaller capital. It simplifies currency management, allowing a trader to transact in different pairs without needing to hold all the involved currencies.
Walking Through a Carry Trade
Assume a short swap rate of 15 pips for CHF/HUF. With each pip valued at 1,000 HUF for a 100,000 CHF/HUF position, that’s a nightly gain of 15,000 HUF (about US$40). Hold this from the 1st to the 30th of December 2022, and you could earn a whopping 450,000 HUF in swaps (nearly US$1,230). However, always consider the possible exchange rate variations which could affect profits.
Navigating the Risks of Carry Trading
All investments have risks, and the primary challenge in carry trading is the exchange rate fluctuations. To maximize success, the positive swaps should consistently surpass any exchange rate losses. Also, keep an eye on interest rates as they could flip a positive swap into a negative one. Using tools like stop losses can mitigate some of these risks, but vigilance is key, especially during central bank rate announcements.
Carry Trading: A Glimpse into its Past
While carry trading might seem like an arcane strategy, it was the talk of the town in the '80s and '90s. The Japanese yen, with its long history of near-zero interest rates, was often the currency of choice for such trades. However, the 2008 financial crisis and the subsequent slashing of interest rates across the globe took the wind out of its sails. Now, with the renewed interest in this strategy, the horizons seem promising again.
Identifying Ideal Currency Pairs
The wider the interest rate differential between two currencies, the better they are suited for carry trading. Platforms like cTrader and MetaTrader 4 are great resources to check current swap rates and to analyze the potential of various currency pairs.
| Currency | Interest rate | Currency | Interest rate |
|---|---|---|---|
| Hungarian forint (HUF) | 13% | Japanese yen (JPY) | -0.1% |
| Mexican peso (MXN) | 10.5% | Swiss franc (CHF) | 1% |
| Turkish lira (TRY) | 9% | Danish krone (DKK) | 1.75% |
| Czech koruna (CZK) | 7% | Euro (EUR) | 2.5% |
| South African rand (SAR) | 7.25% | Swedish krona (SEK) | 2.5% |
| Polish zloty (PLN) | 6.75% | Norwegian krona (NOK) | 2.75% |
| United States dollar | 4.5% |
To successfully harness the benefits of carry trading, it's imperative to pinpoint those currency pairs that present a favorable swap rate. Furthermore, seeking out pairs characterized by minimal volatility can significantly mitigate potential exchange rate uncertainties. Alternatively, if delving into more volatile pairs, ensure the positive swap is substantial enough to counterbalance the inherent risks. This dual approach ensures that while you're capitalizing on interest rate differentials, you're also safeguarding your investments against unpredictable market fluctuations.
| Currency pair | 4-week volatility | Pip value/lot | Long swap | Short swap |
|---|---|---|---|---|
| CHF/HUF | 13.6 | 1,000 HUF | -22.829 | 13.976 |
| EUR/HUF | 11.3 | 1,000 HUF | -21.181 | 12.998 |
| USD/HUF | 15.3 | 1,000 HUF | -16.607 | 10.078 |
| EUR/CZK | 3.9 | 100 CZK | -5.058 | 1.996 |
| USD/CZK | 10.7 | 100 CZK | -26.059 | 5.488 |
| CHF/PLN | 10.3 | 100 PLN | -1.064 | 0.553 |
| EUR/PLN | 3.5 | 10 PLN | -8.592 | 4.279 |
| EUR/MXN | 13.1 | 10 MXN | -68.323 | 28.048 |
| USD/MXN | 8.7 | 10 MXN | -47.4 | 16.156 |
| EUR/TRY | 10 | 10 TRY | -117.425 | 50.645 |
| USD/TRY | 3.3 | 10 TRY | -92.363 | 52.057 |
| USD/JPY | 15 | 1,000 JPY | 1.119 | -2.549 |
Embarking on Your Carry Trading Journey
While most forex brokers have their own dealing desks, they often can't match the swap rates offered by STP brokers. To truly maximize your carry trading potential, consider partnering with an STP broker. In conclusion, carry trading offers a unique avenue for traders, especially in an age of fluctuating interest rates. However, as with all investments, a keen understanding and careful monitoring are key to success.
