Profiting from Currency Carry Trade in Forex

Forex carry trade is a trading strategy where you can profit from the interest rate difference between the two currencies in a currency pair. But just like any other trading strategy, you need to have the right technique and risk management mechanism to ensure you don’t end up losing your investments.

Let's take a look at everything you need to know about carry trade in forex.

What is currency carry trade?

Currency carry trade is a forex trading strategy that involves borrowing a currency with a lower interest rate to purchase a currency with a higher interest rate, with the goal of profiting from the interest rate differential.

This low-risk profit-making strategy is suitable for long-term traders since the return from the differential rate can continue accruing for as long as their position is open.

How does carry trade work?

Two currencies are involved in the fx carry trade: the funding and target currencies.

The funding currency is the low yield or the low interest currency.
The target currency is the high yield or high interest currency in the currency pair.

The first step in a carry trade is to pick currency pairs with interest differentials suitable for the trade. Funding currency is borrowed to purchase the target currency. By borrowing the low yield funding currency to purchase the high yield target currency, the carry trader can profit in two ways:

Interest rate differential

The interest differential rate is the difference between the interest rate of both currencies in the pair. As such, to profit from carry trade, you need two currencies with significant differences in their interest rate.

When trading, you will either be charged or paid an interest rate for holding a position overnight. The overnight interest rate, also referred to as rollover rate, is the difference between the interest rate of the two currencies in the open position.

In the case of carry trade, you will earn or incur interest rates depending on the direction of your position. You can earn interest if you go long on the currency with a high-interest rate, which in this case is the target currency.

You stand to gain more if the initial differential interest increases.

Note that the interest rate of a currency is determined by the central bank of the currency. The bank may increase the interest rate to control inflation or decrease the interest rate to stimulate economic growth.

Exchange rate

The difference in the exchange rate of the two currencies is another mode of gaining profit in fx carry trade. Exchange rate in forex trade is the value of a currency in a pair in relation to the other currency. That is, it defines how many units of a currency you will get in exchange for one unit of the other currency in the pair.

If the exchange rate of one currency in a pair is higher than that of the second currency, you can profit from the difference in their exchange rates by exchanging the currency with the high exchange rate for the one with the low rate.

Example of currency carry trade

Let's assume you start trading with a deposit of $20,000 in your forex trading account. If you choose AUD/JPY pair with the Australian interest rate at 5% and the Japanese interest rate at 1%, the interest differential you stand to gain is 4%, excluding the spread deduction by your forex broker.

Let's assume your forex broker offers 20:1 leverage which you use to open a position of 400,000. This means your deposit is 5% of the total value of the trade.

If you maintain your position and the carry trade remains positive, you will receive 4% interest on the total value of your position every day your position remains open.

On the flip side, if due to any unexpected event, the AUD interest rate decreases to 1% and the JPY interest rate increases by 4%, that is a negative carry. 3% of the whole position, 12,000 AUD, will be deducted from your account every day your position remains open.

If the AUD appreciates relative to JPY, you also stand to make a profit from the exchange rate if you go long the pair at the closing of your position. If the AUD depreciates, you may incur a loss. You may also hit margin calls when all you have left in your account is 5% of the 400,000.

However, if the exchange rate remains constant, you only stand to gain the 5% interest rate from the trade. You will not make more profit or loss.

Trading strategy for forex carry trade

To maximize your position in the forex carry trade, one strategy you can use is to position your carry trade in the direction of the trend. It is beneficial to analyze a market that exhibits a strong trend because the carry trade is a long-term transaction.

As such, you should ascertain an uptrend before getting into higher probability trade. After that, you can now figure out the ideal entry point into the trade using indicators and multiple time frame analyses.

Risks associated with forex carry trade

Risk of interest rate reversal

Your position will be endangered if the interest rate of target currency decreases and that of funding currency increases. Instead of earning the differential interest, the difference will be deducted from your account. The loss might be worse if you used leverage since the interest rate will be calculated on the whole lot and not just your original fund.

Risk of depreciation

If the target currency depreciates relative to the funding currency, you can lose the trade in case you go long. However, you can still earn the interest differential if you maintain your position. To control the situation, you should put in place an effective stop loss order.

Final words

Forex currency carry trade is a long-term trading strategy that promises you handsome profit from a broad differential interest of a pair. However, to maximise your position, you should choose your currency pair meticulously after a thorough fundamental and technical analysis. It would help if you also put in place an adequate risk management mechanism to minimise the loss in case the market moves against your position.

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Disclaimer: All material published on our website is intended for informational purposes only and should not be considered personal advice or recommendation. As margin FX/CFDs are highly leveraged products, your gains and losses are magnified, and you could lose substantially more than your initial deposit. Investing in margin FX/CFDs does not give you any entitlements or rights to the underlying assets (e.g. the right to receive dividend payments). CFDs carry a high risk of investment loss.

What is Carry Trade in Forex?