Talking about international finance, the carry trade is the speculative practice consisting in borrowing money in countries with lower interest rates, to change it in the currency of countries with a greater return on investment.
The goal is to repay the debt of the borrowed money and obtain a gain with the same financial transaction. This allows the trader to profit from the differences between the various markets around the world.
Usually, in carry trading, it is important to choose currencies with a stable exchange rate over time while the investment has to involve low-risk instruments such as government bonds.
The use of leverage helps to multiply the profit, but this also increases the risk taken by traders. For this reason, in Forex, it is often chosen currencies that allow avoiding excessive volatility.
The biggest risk in carry trading is the uncertainty of exchange rates. Leverage also increases this risk as a loss of a few pips can turn into a big loss if you have not taken the proper precautions.
The carry trade is a fundamental mechanism for understanding the dynamics that drive the global financial flows. Strongly influenced by macroeconomic data of different countries and from changes in interest rates set by Central Banks, the carry trade returns often an accurate picture of the perceptions of markets.
This type of financial transaction has become over time more and more decisive for the evolution of exchange rates between the three major currency (dollar, yen, euro) but also in the exchange rate between the three major emerging countries (South African rand, Turkish lira, Mexican peso, Brazilian real, etc. ….) and non emergent but with high rates of return (the Australian dollar and New Zealand).
What is the modus operandi of those who speculate with this type of operation? First of all, it is important to look for a geographic area that is able to offer low rates of return in the short and long-term (where possible) and low risk of a change in monetary policy.
Changes of monetary policy by the Central Bank are a risk and the surprises are not welcome.
Second, we must look for geographical areas that have possibly yield on short-term rates (1-3 years) significantly higher than the rate of the currency borrowed in the first area.
What makes the carry trade special in the Forex market is that interest payments are made every trading day. Technically, all positions are closed at the end of the day.
Brokers close and reopen the positions, and then they debit/credit to the trader the overnight interest rate difference between the two currencies. This is the cost of “carrying” (also known as “rolling over”) a position to the next day.
Most Forex trading is margin based, meaning you only have to put up a small amount of the position and you broker will put up the rest. Many brokers ask as little as 1% to 2% of a position. That is a deal.
So, it seems that carry trade means also easy money, but anything that seems too good to be true probably is and at some point it must come to an end.