Forex Carry Trade Strategy

What is the carry trade? The carry trade is a name given to the strategy in which

a simultaneously borrowing and selling of a currency with a relatively low interest rate takes place in which the purchase of a currency yielding a higher interest rate. What results is a way to capture the interest rate "carry" or rollover

You could then decide to invest that capital into an asset class with a higher yield (say 7%), earning yourself $60,000. As a result of the interest rate spread between the two, you would earn a handy $60,000 with just a keystroke. At 10 to 1 leverage, you could earn $600,000 for the trade.

The dollar, because of low interest rates, is increasingly becoming a vehicle for the carry trade. Global bankers borrow the dollar while investing in higher dividend paying currencies pocketing the differences.

This cheap borrowing funnels itself into other assets commanding higher interest rates in turn can create other asset bubbles. If the greenback increases interest rates, the whole process becomes unglued.

The Japanese economy has experienced near zero growth because of their low-interest policies. A permanent trade surplus as accrued to Japan because of extremely low interest rates. Debtors gain from low interest rates but savers lose.

Yen Carry Trade Example: Generally, traders look to buy currencies in countries with high interest rates and seek to short currencies in countries that offer low interest rates. GBP/JPY, GBP/CHF, AUD/JPY, EUR/JPY, CAD/JPY, and USD/JPY are currency pairs that are usually selected to apply this strategy. Second tier currencies are more volatile, carry higher interest rate incentives and more profit potential.

The Unravel Risk: When a carry trade unravels it can be risky, especially when it is highly leveraged. When everyone heads for the exits at the same time, markets collapse. This can happen when the dollar rallies causing the entire principle behind the trade to vanish.

With the US central bank flooding the world with dollars, short term interest rates are extremely low. This enables investors world-wide to borrow dollars at next to nothing interest rates and invest them elsewhere at higher rates. The dollar carry trade strategy in one of the reasons the dollar has continued to fall in value. If everyone heads for the exits to cover their shorts, a world financial panic could result.

by: Donna Madlow

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