Forex Trading Education - What is a Carry Trade?

By: Harold Hsu

You've read about it in the newspapers, and you see it in almost every financial trading magazine... but what exactly is a carry trade? And why is it so popular?

Before I go into what happens in carry trades, allow me to briefly share with you why "carry trade" is an important concept to understand...

Throughout most of 2006 and 2007, carry trades have played a major role in influencing the major trends of various currency pairs. Just take a quick look at the EURUSD, USDJPY, AUDJPY, CADJPY or NZJPY trading charts during this period and you'll see what I mean. You'll notice a major uptrend across these currency pairs, and this is mainly due to the effect of carry trades. If you were in-the-loop during this period, you'd undoubtedly be a very rich trader by now! All you had to do was to trade in the direction of the trend and you'd be winning big most of the time.

Simple Carry Trade Theory

Thankfully, the concept of a carry trade isn't difficult to understand. Let me use an example to illustrate:

Imagine there are two banks. Bank A charges an interest rate of 8% a year, and Bank B charges an interest rate of 2% a year.
If you're a quick thinker (and I'm sure you are), you'll realize that you can just borrow money from Bank B, and deposit that money in Bank A (to earn interest) for a sure profit!

And this simple technique is basically what carry trades are about. The difference is that instead of exploiting the interest difference between Bank A and Bank B, institutional traders and fund managers exploit the difference between the interest differences between countries.

Carry Trades In Reality

In reality, people like to borrow the Japanese Yen (JPY) to purchase other 'higher interest rate' currencies such as the New Zealand Dollar (NZD) and the Australian Dollar (AUD).

This is because the Yen typically charges a relatively low interest rate of 0.5%, compared to the NZD and AUD which interest rates are roughly 6-8%.

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