All Good Things Come to an End: The Fall of the Carry TradeAll Good Things Come to an End: The Fall of the Carry Trade
One of the most popular currency trading strategies in recent history, the carry trade has been successfully used by traders for years. With recent market conditions, this very popular strategy is beginning to look like a losing proposition. Traders find themselves wondering is this strategy ever going to be back en vogue or will it remain taboo for generations to come? The answer is murky at best and highly dependent on the global economy and the foreign exchange market. Let's start to evaluate this by taking a look at current market conditions.
What is the Carry Trade and How does it work?
Before one can understand why the carry trade isn't working, one must first understand what the carry trade is. The short answer is that the carry trade is a trade where a currency trader or speculator is attempting to not only gain from the rise or decline of the currency pair, but also the interest rate differential between the two currencies. When carry trading, the trader buys the currency with the higher interest yield while selling the currency with the lower interest. The speculator is attempting to capture the interest rate differential as well as any appreciation in the currency. The carry trader is often more interested in the positive interest earned on the currency pair rather than the profits from the trade itself.
Sample carry trade:
Trader Buys New Zealand Dollars (Earns 7%)
At the same time, Trader Sells Japanese Yen (Pays 0.25%)
If the currency pairs stays at the same rate for the entire year trader makes 6.75% (Interest Rate Difference)
If this is a 100k position, the trader has earned 6.75% interest on 100,000. With 10:1 leverage, the trader put up 10k and earned $6,750NZD.
In the recent past, the NZDJPY has often been a great example of the carry trade strategy. Forex traders bought this currency pair not for economic growth in the New Zealand economy, but for its carry trade opportunity. Currency traders jumped at the chance to earn the high 8 percent interest rate that the Reserve Bank of New Zealand was offering at the time while simultaneously, paying a cost of 0.5 percent for the Japanese Yen. This 7.5% rate on margined funds lead to huge potential gain which helped money managers garner a high return coupled with the rise in the currency as the New Zealand dollar appreciated against theYen.
One of the most popular currency trading strategies in recent history, the carry trade has been successfully used by traders for years. With recent market conditions, this very popular strategy is beginning to look like a losing proposition. Traders find themselves wondering is this strategy ever going to be back en vogue or will it remain taboo for generations to come? The answer is murky at best and highly dependent on the global economy and the foreign exchange market. Let's start to evaluate this by taking a look at current market conditions.
What is the Carry Trade and How does it work?
Before one can understand why the carry trade isn't working, one must first understand what the carry trade is. The short answer is that the carry trade is a trade where a currency trader or speculator is attempting to not only gain from the rise or decline of the currency pair, but also the interest rate differential between the two currencies. When carry trading, the trader buys the currency with the higher interest yield while selling the currency with the lower interest. The speculator is attempting to capture the interest rate differential as well as any appreciation in the currency. The carry trader is often more interested in the positive interest earned on the currency pair rather than the profits from the trade itself.
Sample carry trade:
Trader Buys New Zealand Dollars (Earns 7%)
At the same time, Trader Sells Japanese Yen (Pays 0.25%)
If the currency pairs stays at the same rate for the entire year trader makes 6.75% (Interest Rate Difference)
If this is a 100k position, the trader has earned 6.75% interest on 100,000. With 10:1 leverage, the trader put up 10k and earned $6,750NZD.
In the recent past, the NZDJPY has often been a great example of the carry trade strategy. Forex traders bought this currency pair not for economic growth in the New Zealand economy, but for its carry trade opportunity. Currency traders jumped at the chance to earn the high 8 percent interest rate that the Reserve Bank of New Zealand was offering at the time while simultaneously, paying a cost of 0.5 percent for the Japanese Yen. This 7.5% rate on margined funds lead to huge potential gain which helped money managers garner a high return coupled with the rise in the currency as the New Zealand dollar appreciated against theYen.
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