Trading Forex- Exotics as Carry Trade

By: Mike P. Kulej
The carry trade is an investment strategy involving basic arbitrage between interest rates. Any Forex transaction comprises of simultaneously selling one currency and buying another. Object of the carry trade is to sell a currency with a low interest rate and purchase one with higher interest rate. Trader pays interest on the sold part of the trade and collects it on the currency that was purchased, capturing the rate differential.

This easy strategy has been a buzzword in Forex circles for many years. There are always differences in interest rates to be exploited and sometimes they are quite substantial. To make it more appealing, these imbalances can last for a long time, years even, making the carry trade a darling among the "easy money" crowd. Such was the case for JPY which had been heavily borrowed for years in order to buy NZD, AUD and GBP, until last summer. That's when the now famous "unwind of the carry trade" took place, sinking a lot of over leveraged traders.


Since then financial press has been relatively quiet on the subject. Recently, though, new variants of the method have started to pop out. On of them involves USD being sold against a basket of other currencies. It is based on the premise that FED will continue to cut rates and the dollar will continue its weakness unabated.

Since the outcome for rates of other major economies is also very uncertain, hence the basket of currencies. This makes it for a rather complicated strategy, requiring careful allocation within the basket. This particular a approach makes the carry trade a little more complicated than it needs to be.

Another option gaining attention of late is the use of emerging markets currencies, also known as exotics. Some of the relatively high yielding ones are, as of this writing, Brazilian Real, Mexican Peso, Turkish Lira and South African Rand. While they are not available on all platforms, more and more brokers are adding at least some of them to their offerings. As of late, Rand (ZAR) and Lira (TRY) seem to be leading the pack.

South African Rand has been actively traded for many years now, has accumulated a wealth of historical data and is probably most suitable for individual trader. South African Reserve Bank's overnight rate stands 11%. Rates have been cut four times last year and this trend is expected to continue. This country has benefited enormously from the commodities boom, especially the metals. It's not without serious problems though, very high unemployment rate, political instability, and failing infrastructure (electricity shortages) are sure to have effect on the Rand. This currency is available on most of the leading broker's platforms.

Turkish Lira currently offers the highest interest rates in the industrial world. The benchmark overnight rate was standing at 15,25% lately. In 2001 the country started reforms, backed by International Monetary Fund, which greatly improved economic stability. This led to Turkey being one of the fasting growing economies in the world, for a few years running. Prospective European Union membership also increased the flow of foreign investment. However, country has to overcome very high level of deficit and external debt. Political instability is always possible, as well as the ever present threat of a military conflict with its Kurdish minority.

These exotics certainly offer interesting and tempting opportunities for carry trade enthusiasts. Combined with daily interest payouts and massive leverage availability, they are sure to draw attention of speculators. Let's not forget, however, that the potential for loss is also high. During adverse times, exotic currencies will tend to move much faster than others. While worthy a second look, this carry trade is probably best suited for the most adventures traders, no matter how much hype surrounds it.

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