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Forex trading course: What is the currency carry trade?

One of the terms that may crop up as part of a Forex trading course is the carry trade. What is the carry trade and how does it influence Forex trading?

The carry trade is actually the most popular in the currency market. In essence it's all about interest rates and the fact that for each currency, be it the GBP, EUR, USD or whatever, there is a bank base rate attached to it.

Interest rates are controlled by central banks, such as the Federal Reserve in the US, the Bank of Japan in, er, Japan and the Bank of England in the UK.

What happens in a carry trade is that the trader goes long (ie places a "buy" trade) on the currency with a high interest rate, financing that purchase with a currency with a low interest rate. So, the trader is relying on the high interest rate currency to gain on the low interest rate currency.
Looking back to 2005 we can see one of the best carry trade scenarios in action with the NZD/JPY cross. New Zealand saw its rates rise to 7.25% and hold firm off the back of a booming housing market and commodity demand. Further round the Pacific Rim, Japanese rates were at 0%.

So how would it affect the trade? Well, essentially what the trader is doing is borrowing money in a low-interest rate currency and buying higher-yielding assets in a different currency. Add in leverage and you get some very large potential gains. In the case of the NZD/JPY example, this could amount to 72.5% annually with a 10:1 leverage.

Sounds like money for nothing, but of course it is not. Taking the yen as an example again, in 2007 the Japanese currency rebounded sharply against the US dollar in April as the Bank of Japan tightened the money supply. For the carry trade, it meant speculators were bailing out to repay their yen debts.

Indeed, declines can be very rapid and severe, a process known as carry trade liquidation. Once every trader sees there is no future in a particular carry trade they all rush to exit their position at same time. Cue bids starting to disappear and because profits from interest rate differentials are not enough to offset the capital losses, it can be bad for the trader.

Anticipation is the key to success: the best time to position in the carry is at the beginning of the rate-tightening cycle, allowing the trader to ride the move as interest rate differentials increase. Essentially, the carry trade isn't for the retail trader - the "little guy". It's used only by the big banks and hedge funds, because potential losses are simply enormous once things go bad.

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