Cash in on the Carry Trade

The concept of carry trading is, by standard of the financial markets, a relatively new investing concept. Prior to the late 1970s, all international trade in currencies was conducted at prices moderated by government. As a result, the opportunities to generate carry trade profits were limited, since international bookkeeping was done mostly with the help of gold weight, not by paper.

However, as international finance grows freer, and currencies around the world sell in an open market against one another, rather than against their weight in gold, the opportunities for carry trade profits are plenty.

What is the Carry Trade?

A carry trade is a trade that is made for the sole purpose of generating a positive carry return. You've undoubtedly heard people describe an investment as negative or positive carry. A piece of land, for example, is negative carry since it generates no cash flow. A rental unit, however, is positive carry because it generates rental income.

However, you don't have to be a landlord or a farmer to take advantage of positive carry. In fact, the easiest to find and largest source of positive carry income is found electronically, on any computer around the world in the foreign exchange market.

Foreign Exchange Carry Trading

Carry trades on the forex market are made by purchasing a high yielding currency with a low cost of carry currency. For example, if the US dollar cost 1% to borrow and the Euro paid 5% in interest, an investor could borrow dollars at 1%, convert to Euros and pocket 5%, and take home 4% every year.

However, that example does not take into effect the importance of leverage in a carry trade. As you're probably well aware, foreign exchange brokers offer more leverage than any broker in any market. Therefore, if you were to make the above trade with more leverage, say 10:1, the cash on cash return on your carry trade would be 40% per year, assuming there are no large swings in the exchange rate.

For the above trade to be profitable at 10:1 leverage, the EUR/USD pair must end the year at a price lower than 4% of its opening price, nor can at any time the pair fall more than 10% from the time of purchase. If the pair declines more than 10%, a margin call will be enacted at 10:1 leverage. If the pair used in the carry trade ends the year at a price lower than 4% below the opening price, then the value of the positive interest is negated.

In order to secure a portfolio against market movements, investors usually place carry trades in a number of different currency pairs, hedging their risk. Commonly, two countries with similar economies, such as New Zealand and Australia, are used in tandem with one other currency in a long/short trade. Shorting the NZ Dollar and longing the Australian Dollar against a low cost currency allows for investors to extract carry interest from the trade, but also hedge against changes in the fundamentals of New Zealand or Australia.
Tim Ord
Ord Oracle

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