Forex Recipe

The Carry trade can be described as a strategy in which an investor sells a certain currency with a comparatively low interest rate and buys a different currency that would yield higher interest, using this fund. It is a trading system in which you make money if price stayed unchanged for long period of time.

By manipulating the difference between rates and other factors like leverage, a trader employs the strategy to earn profit. This is particularly true for the spot forex market, where the leverage is high, and because the interest payments happen every trading day based on your position.

A broker closes and reopens your position and debit or credit you the overnight interest rate difference between the two currencies. This derives the name of carrying or rolling over.

For example, a trader borrowed 1000 yen from a Japanese bank and exchanged this for USD to buy a financial instrument, say, a bond for the equivalent amount. If the bond pays an interest of 4.5% and the Japanese interest rate is 0%, the trader made a profit of 4.5%, if the exchange rate between the countries remained unchanged. With leverage, this strategy can return huge profits. Say, if you have a common leverage of 10:1, the profit explained in the above example becomes 45%.

The risk is of course the uncertainty of exchange rates. If the USD was to fall relative to the yen, the trader would have lost money. High leverage can even intensify the risk to much greater degrees.

The strategy may not prove to be of any great potential in future as Japan and the EU are increasing their interest rates. The interest rate differentials are narrowing now making the situation for forex carry traders. The only solution would be apply a little more imagination and to look beyond the interest rates. The traders now should focus on currency fundamentals, like economic indicators, the actual supply and demand relationship for any particular currencies, etc.

This entry was posted on Friday, July 11th, 2008 at 10:03 am and is filed under Forex Market. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.