If you are holding a position past 10pm GMT you will earn interest when you are long on the currency with the higher interest rate. In the same way, when you are long on the currency with the lower interest rate you pay interest when holding a position past 10pm GMT.
In the same way that the US investor in the example from the previous lesson took his US Dollars and invested them in New Zealand Bonds to earn a higher return, currency traders can also take advantage of countries which offer higher interest rates. However taking advantage of interest rate differences between countries is generally a lot easier for currency traders to do as this can be done with a simple click of the mouse.
To assist in demonstrating this, it is useful to look at the interest rates as set by the central banks for the main currencies which we are interested in. For the purposes of this example and as we covered in our last lesson, rates as set by the Federal Reserve in the United States are currently at 2%, and rates as set by the Bank of New Zealand are currently at 8.25%.
Now go to the Market Watch window of the your trading platform and find the New Zealand Dollar/US Dollar Currency pair. If you buy this currency pair, then you are long the New Zealand Dollar which is the higher yielding currency, and short the US Dollar which is the lower yielding currency. Bearing this in mind you earn interest on each contract held past 10pm GMT. On the other hand, if you sell this currency pair then you are short the higher yielding New Zealand Dollar and Long the lower yielding US Dollar, so you pay interest on each contract held past 10pm GMT.
As evidenced here, you can take advantage of the higher interest rates in New Zealand by buying New Zealand Dollars and Selling US Dollars directly through the forex trading platform, and without having to go through the trouble of figuring out how to buy New Zealand bonds as you would have had to in our previous lesson.
Due to the simplicity of this strategy and the fact that as well as the interest that you can earn by being long the currency with the higher interest rate there is the opportunity for capital appreciation should the higher yielding currency move in your favor, this is an extremely popular strategy. This is important to you as a trader not only because it is a strategy that you might wish to consider using at some point, but also due to the fact that a very large amount of capital flows in and out of currencies based on this strategy, which makes it a major market mover in both the long and short term.
Finally, it is important to understand that when a trader is long the carry, which means that the trader is long the currency pair with the higher interest rate, then that trader is normally getting paid for each day that they hold their position, in spite of what happens to the exchange rate. On the other hand when a trader is short the carry, which means that they are long the currency pair with the lower interest rate, then they are normally paying money on a daily basis, no matter what happens with the exchange rate.
As we discussed in the previous lesson, if a trader buys the NZD/USD currency pair, then they will earn interest on each contract held past 10pm GMT on Monday, Tuesday, Thursday, and Friday. As we saw in our discussion on rollover, they will earn 3 days worth of rollover on Wednesday to take into account Saturday and Sunday when the market is closed. Assuming that this rollover was earning $15 per day, then this would bring the total interest paid for the 7 days in the week to 7 * 15 = $105. As there are 52 weeks in a year if a trader decided to hold this position for a whole year and the rollover rate did not change, they would earn (105 * 52) = $5460 in interest from the rollover portion of the trade.
For the purposes of this lesson the current market rate for NZD/USD is .7687 which is an annual return from just the rollover portion of the trade of $5460/$76,870 = 7.1%. It should be noted we are making extreme assumptions for the sake of simplicity that the exchange rate and rollover rate will remain the same as they are today for the 1 year period that the trader is in the trade.
At this point you may be wondering why this strategy with the carry trade is so popular with all the risks involved and only a 7.1% return. However if you were to utilize the leverage that is available to you on the forex market, as discussed in a previous lesson, then you could use that 7.1% return and make it into a much more attractive prospect. With this in mind, if you leveraged this position at 2 to 1, which most traders would consider to be a very moderate use of leverage, then you would double your return from the rollover to 14.2%. It should be noted that if you were able to consistently generate a return this would outperform the long term average return of the US Stock market. Now consider what would happen if you increased your leverage to 3 to 1 or 4 to 1. This would provide you with a return from rollover of 21.3% and 28.4% respectively.
Now before you decide to jump right into a carry trade, bear in mind that while this is an attractive return and while there are many traders who have made good profits using carry trade strategies, there are some other important things to consider:
Exchange Rate Fluctuations which can cause additional profits or wipe out all profits and cause losses on the trade.
Changes in Interest Rates which can increase the positive rollover, decrease it, or cause a trader to end up paying for holding the position instead of earning.
The Use of Leverage amplifies any gains made on the strategy but also amplifies any loss should the trade begin to work against the trader.
It is the way in which traders handle these unknowns that distinguishes traders who consistently make profits from carry trade strategies from those who do not, and we will discuss this further later in the lesson.
As discussed previously, it is the size of the difference between interest rates in the countries whose currencies we are trading that ultimately decides the amount that we either pay or receive for holding a position past 10pm GMT. Therefore it is only reasonable that if the difference in interest rates between two countries changes, then so will the rollover amount that is either paid or collected when trading those country’s currencies.
For a short example let’s revisit the NZD/USD. For the purposes of this lesson if you were to buy the NZD/USD currency pair then you would earn $10 for each contract you held past 10pm GMT. You would earn $10 because you are long the NZD where currently interest rates are at 8.25% and short the USD where interest rates are currently 2% for the purposes of this lesson. Therefore, you are long the positive interest rate differential of 8.25%-2% which equals 6.25%.
Now let’s assume that interest rates in the United States go up by 1% to 3%, while at the same time interest rates in New Zealand stay the same. If this occurred then your positive interest rate differential of 6.25% would fall to 5.25%. Therefore it is clear to see that as the positive interest rate differential has decreased, the amount of money that you earn for holding the position has decreased as well.
On the other hand, if rates went up in New Zealand and stayed the same in the United States then the interest rate differential would increase in your favor, and the amount you would earn for holding a position past 10pm GMT would also increase. Therefore, one of the first things that you must take into account when thinking about a carry trade is what the current interest rates are, and what they are expected to be for the life of the trade.
Another thing to consider when thinking about a carry trade is exchange rate fluctuations that may occur while a trader is in the position. A traders may consider several things here, the most popular of which are one of or a combination of the following:
The most important thing here is interest rate expectations. As we covered previously when discussing how interest rates move the FOREX market, when interest rates rise in a country, interest bearing assets will generally become more attractive to investors, which will drive the value of a currency up, and vice versa when interest rates fall, all things being equal. Note that the key word here is “expectations” when we refer to interest rate expectations. Markets anticipate fundamentals so generally once an interest rate increase or cut is announced it has already been priced into the market.
The most important thing to consider here is affects on the current account.
Due to the fact that carry trades are normally long term trades many traders will examine the overall trend in the market and apply technical analysis to try and determine when they believe that the trend is going to be in their favor if they open a carry trade.