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What is a Carry Trade?

What is a Carry Trade?
June 07
02:33 2011

The carry trade consists of a trading strategy generally employed by banks, investment funds and traders in the forex market. The use of this strategy shifts large amounts of international capital from one currency to another.

In essence, the carry trade simply takes advantage of the difference in interest rates between the long currency — which “carries” the higher interest rate — and the short currency, or the funding currency.

Positive and Negative Carry

Basically, when establishing a forex position, the trader is simultaneously holding and selling short funds of different nations.  The funds which the trader has bought and sold have different interest rates either being paid on those funds, or in the case of a short currency, to be paid by the trader for being short those funds.

Receiving an interest payment on a currency position occurs every business day at 5PM EST when trading forex in the United States, which is when funds “rollover”. This is known as a positive carry and occurs when the trader is holding a long position in a currency pair such as the Australian Dollar — with a high interest rate — versus the Japanese Yen — with a low interest rate —for example.

The interest rate in Australia at the time of this writing is 4.25%, while the interest rate in Japan is 0.0 to 0.25%. The difference being a positive carry of +4.0%, which if the position were reversed, with the trader holding a short position in the Australian Dollar and long the Japanese Yen would make up a negative carry of -4.0%.

This 4.0% is calculated on the amount of the trader’s forex position daily and paid out or debited to their trading account after the 5PM rollover time in New York. Although 4.0% may seem like a small amount, when leveraged it can provide a generous interest income.

Market Appreciation

In addition to the interest on funds the carry trade provides, another factor that makes the carry trade especially attractive to traders consists of market appreciation. For example, in the above example, long Aussie/ short Yen, the Australian Dollar has soared against the Japanese Yen.

Therefore, in addition to a 4.0% annual return, while holding the position, the trader also benefits from the upward move in the Australian Dollar versus the Japanese Yen. This stands to reason since the Australian economy has proven stronger than the Japanese economy recently.

Which makes up one of the reasons for the interest rate differential, the higher interest rate in Australia serves to keep inflation in check, while the ultra-low interest rate in Japan has the intent of stimulating their weaker economy.

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