Currency Carry Trades in Forex Trading
What is Currency Carry Trades?
Currency carry trades (also called Carry Trading) is a way to obtain profits from the interest rate differentials between currencies. A Currency carry trade involves borrowing at a low interest rate and investing in an asset or security that offers a high yield return. The yield of the investment should be higher than the borrowed capital.
The objective of the Carry trade is to do it on a large scale. The carry trades are usually conducted by large financial institutions that have access to low-cost funds.
Carry Trades are a very dangerous strategy since they are highly volatile and involve high risk.
Mechanics of Earning Interest
Currency carry trades are constructed by borrowing at a low interest rate in one currency and investing in another currency. For example, an investor borrows Euros (EUR) by selling them forward for U.S dollars to purchase Australian dollars in 3 months. The spot price is 1.1050 EUR per USD which means that one Euro can buy 1.1050 USD.
The investor then uses the borrowed Euros to buy Australian dollars (AUD), trading at 0.7680 AUD per EUR in the spot market. This transaction generates positive cash flow for the investor since he borrows low and invests in high yielding currency (Australian dollar).
Currency carry trades are generally small relative to the total assets in an institution's portfolio. As a result, a significant negative movement in the currency exchange rate may overwhelm other investments that would usually reduce or hedge the position. This can lead to significant losses for large financial institutions.
Risk of Currency Carry Trade
The currency carry trade carries significant risk because the traders are exposed to changes in exchange rates. Incorrect forecasting of which way the currency will move can lead to significant losses for an investor. It is virtually impossible to predict the direction of change in currency prices, especially against major currencies like the Dollar and Euro.
Many trading firms and hedge funds have lost significant amounts of money due to currency carry trades. One such example is Bruno Iksil, a London-based trader for JPMorgan Chase & Co who made wrong bets and lost more than $2 billion. This incident is known as the "London Whale" crisis, one of the largest trading losses in history.
When these rates converge, an investor can lose on both fronts; one from the loss on the investment and second from the cost of carrying (interest on debt). At present, there is significant divergence/disparity in interest rates between major economies.