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Learn more and compare subscriptions content expands above. Full Terms and Conditions apply to all Subscriptions. By Dewi John January magazine. The carry trade may be making a comeback, after a decade in the doldrums, laid low by the global financial crisis.
But as markets have shifted and, should it become a significant option for investors, they will have to tread carefully. This may be no bad thing. Carry trade strategies are where an investor borrows in a low-interest-rate environment to fund purchases in a high-interest-rate one see box.
These come in several guises: for example, fixed income or volatility. The best-known carry strategy, however, is the currency trade. These trades work well when currencies are stable and, prior to the financial crisis, seemed like the nearest thing to a free lunch that the markets had to offer for investors. That stability can last for a considerable time while the conditions that support it continue. However, the danger is that when conditions change, they change quickly, as events a decade ago demonstrated.
They converted the yen into currencies backed by high interest rates, such as the Australian dollar. The yen carry reversed sharply as global interest-rate differentials narrowed, causing the yen to rally against higher-interest currencies. As a result, participants suffered significant losses.
As it was and is common for such trades to be leveraged — up to to times — losses would certainly have been in excess of this. However, this is something that the investment parameters of pension funds could protect them from. The collapse in growth post and the ensuing financial repression of quantitative easing QE made the carry trade a less remunerative proposition as interest rates hit lows on a global basis. These unpromising conditions did, however, begin to change mid-decade.
Any hint of intervention could reverse the gains in the carry trades. An effective carry trade strategy does not simply involve going long a currency with the highest yield and shorting a currency with the lowest yield.
While the current level of the interest rate is important, what is even more important is the future direction of interest rates. For example, the U. Also, carry trades only work when the markets are complacent or optimistic. Uncertainty, concern, and fear can cause investors to unwind their carry trades.
Since carry trades are often leveraged investments, the actual losses were probably much greater. When it comes to the carry trades, at any point in time, one central bank may be holding interest rates steady while another may be increasing or decreasing them. With a basket that consists of the three highest and the three lowest yielding currencies, any one currency pair only represents a portion of the whole portfolio; therefore, even if there is carry trade liquidation in one currency pair, the losses are controlled by owning a basket.
This is actually the preferred way of trading carry for investment banks and hedge funds. This strategy may be a bit tricky for individuals because trading a basket would naturally require greater capital, but it can be done with smaller lot sizes. The key with a basket is to dynamically change the portfolio allocations based upon the interest rate curve and monetary policies of the central banks.
The carry trade is a long-term strategy that is far more suitable for investors than traders because investors will revel in the fact that they will only need to check price quotes a few times a week rather than a few times a day. True, carry traders, including the leading banks on Wall Street , will hold their positions for months if not years at a time.
The cornerstone of the carry trade strategy is to get paid while you wait, so waiting is actually a good thing. Partly due to the demand for the carry trades, trends in the currency market are strong and directional. This is important for short-term traders as well because in a currency pair where the interest rate differential is very significant it may be far more profitable to look for opportunities to buy on dips in the direction of the carry than to try to fade it.
The best way for shorter-term traders to look at interest is that earning it helps to reduce your average price while paying interest increases it. For an intraday trade, the carry will not matter, but for a three-, four- or five-day trade, the direction of carry becomes far more meaningful. Advanced Forex Trading Concepts. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.
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Basic Forex Overview. Key Forex Concepts. Currency Markets. Advanced Forex Trading Strategies and Concepts. Table of Contents Expand. Carry Trade. The Mechanics of Earning Interest.
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