Carry trade strategies

A carry trade happens when you buy a high-yielding currency

and sell a relatively lower-yielding currency. The strategy prof-

its in two ways:

By being long the higher-yielding currency and short

the lower-yielding currency, you can earn the interest-

rate differential between the two currencies, known as

the carry. If you have the opposite position — long the

low-yielder and short the high-yielder — the interest-rate

differential is against you, and it is known as the cost of

carry.

Spot prices appreciate in the direction of the interest-

rate differential. Currency pairs with significant interest-

rate differentials tend to move in favor of the higher-

yielding currency as traders who are long the high

yielder are rewarded, increasing buying interest, and

traders who are short the high yielder are penalized,

reducing selling interest.

So let me get this straight, you may be thinking: All I have to

do is buy the higher-yielding currency/sell the lower-yielding

currency, sit back, earn the carry, and watch the spot price

move higher? What’s the catch?

The catch is that downside spot price volatility can quickly

swamp any gains from the carry trade’s interest-rate differen-

tial. The risk can be compounded by excessive market posi-

tioning in favor of the carry trade, meaning a carry trade has

become so popular that everyone gets in on it. Figure below illus-

trates the trending price gains of a carry trade, punctuated by

sudden price setbacks.

Carry trades usually work best in low-volatility environments,

meaning when financial markets are relatively stable and

investors are forced to chase yield. Keep in mind that carry

trades need to have a significant interest-rate differential

between the two currencies (typically more than 2 percent) to

make them attractive. And carry trades are definitely a long-

term strategy, because depending on when you get in, you

may get caught in a downdraft that could take several days or

weeks to unwind before the trade becomes profitable again.

Figure NZD/JPY trends higher in line with carry trade fundamentals

(New Zealand’s interest rates are much higher than Japan’s), but it meets

sharp setbacks along the way.