How to use the carry trade in forex

If you’re a forex trader, or interested in starting, you’ll probably notice market commentators talk a lot about interest rates. Investors follow interest rates decisions for several reasons. For example, with low interest rates, the cost of borrowing usually decreases. This means that companies will spend less money on servicing their loans. It also means that individuals can borrow and spend more. Another reason why investors follow interest rates is the carry trade. This article will explain what a carry trade is, and how you can use it to maximize your returns.

What is a Carry Trade?

To better understand what a carry trade is, it is important to understand the concept of interest rates. Interest rates are set by a central bank to ensure the financial stability of a country. In theory, when interest rates are low, they are supposed to stimulate spending by both companies and individuals. This is usually a good thing for the economy because increased spending leads to more jobs.

When the period of low interest rates extends for a long time, there is a risk it can lead to bubbles in the market. This happens as people use the borrowed money to invest in assets like real estate, which drives up the price to unsustainable levels. To prevent a bubble, central banks tend to intervene and raise interest rates. When interest rates are high, the spending decreases and investors move their funds to high-yielding bank accounts and government bonds.

While the world economy is more synchronized than ever, central banks tend to have differing opinions on interest rates. For example, since 2015, the US Federal Reserve has raised interest rates eight times. At the same time, other central banks in Europe and Asia have avoided raising rates. In fact, some central banks in Europe such as the ECB, Sweden’s Riksbank and Denmark’s Central Bank have maintained negative interest rates. The same is true with Japan.

As a result, the concept of carry trade involves borrowing money in countries with low interest rates and investing in high-yielding countries. The simplest way to explain this is person A and two banks: bank B and C. If a bank account at bank B yields 1% a year while bank C yields 2%, person A can borrow funds in bank B and invest them in bank C. At the end, the person’s profit will be the spread between the interest rates of bank C and B.

In forex, a good example of a carry trade is that of Swiss franc and South African rand. For years, the Swiss National Bank has maintained interest rates at minus 0.75% and investors expect the bank to lower the rates to minus 1% at the end of the year. At the same time, the South African central bank has maintained interest rates at above 6.5%. Therefore, a large investor can go to Switzerland, borrow money at the negative interest rates and invest in the South African rand with its 6.5% yield. If all factors held constant, it means that the yield of the investor will be more than 7%.

Another common example of carry trade is the USD/JPY pair. This is usually a good trade because the US and Japan are major, stable economies. The base lending rate in Japan is at -0.1% while that of the United States is at 2.25%. In this carry trade, an investor borrows the yen at extremely low interest rates. They then convert the yens into dollars, which are then invested in US treasuries or other high-yielding instruments. After a short period, the investor exits the trade at a profit.

In forex trading, you can apply the same concept by first understanding where the interest rates of the two economies are. After this, you should use the available data and the statements from the central banks to determine whether rates will rise and fall. For this, an economic calendar and popular news platforms can help you out. After understanding this, you can initiate a trade like shorting the yen and buying the US dollar.

Final Thoughts

Carry trade is a popular strategy regularly applied by large banks, companies, and investment managers. However, as an individual trader, you too can apply the strategy and profit from the differentials in interest rates. As with all strategies, carry trade comes with risks such as a sudden change in interest rates. To stay safe, it is recommended that you use risk management strategies like using a stop loss and using only a small amount of leverage.

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