A simple trade when understood well and executed with diligence, the “carry trade” can be a trader’s long-term friend. We will briefly look at the mechanics of the system and show examples of the advantages.
Let’s imagine if you could borrow at 3% from Barclays Bank and could get a savings return of 14% from BACEN, (Central Bank of Brazil)?
This would be a dream come true as you would borrow millions and get a net return of 11% per year for doing absolutely nothing!
Unfortunately, the carry trade is not a new theory and it is the banks that are the ones making huge sums of money by offering low savings rates and higher borrowing rates.
But it does not mean that taking advantage of interest rate differential is not an option.
A carry trade is “borrowing” or selling one currency with a low interest rate, then using it to buy currency with a higher interest rate.
While you are paying the low interest rate on the currency you "borrowed” or sold, you are collecting a higher rate of interest on the currency you purchased
In the cash Forex market, interest payments take place every trading day based on your position, as the positions are squared-off and rolled over to the next day.
Brokers close and reopen your position, and then they debit or credit you the overnight interest rate difference, (between the two currencies). Which therefore means that if the currency does not move many pips in a year, you still collect.
For example, let’s say you place $10,000 in a trading account and you have 1:100 leverage on your trading account
You can place $1000 on margin to control $100,000
If the interest rate differential of the pair is 3% then you would make $3000 (3% of $100,000) over the year if nothing happens to the currency – i.e. The rate stays fixed – thus a 30% return on your $10,000 over the year!
If the currency pair fell (declined in value), your risk is your margin on the trade – in this case $1000
Lets look at examples of long and short positions that can be taken to effectively utilise the carry trade:
Long Trade (AUD/EUR)
I am buying AUD (receive 2.25% interest)
I am selling EUR (pay 0% interest to borrow)
Net profit on the deal = 2.25%
Short Trade (USDRUB)
I am selling USD (pay 2.25% interest to borrow)
I am buying RUB (receive 7.5% interest)
Net profit on the deal = 5.25%
(Please note that interest rates are true at time of writing).