Hello everyone, I am a new member of the great Dukascopy community and this will be my first of many articles. I feel like this is the perfect subject to start with because the explanation of a carry trade brings us back to the very basic fundamentals of forex trading. So here we go!


Definition of a carry trade:

A carry trade consists of borrowing money in a currency with low interest rates and investing the funds in another currency with higher interest rates.

This is a pretty straightforward definition, but let's use an example to put this information into context. If the interest rate of the European Central Bank is 0% while the US Federal Reserve is 1,75%, the interest rate spread would be 1,75% (1,75% - 0%). In this example, we would borrow Euro to invest in USD therefore the net yield of the carry trade would be a gain of 1.75% or 1,750$ a year for 1 lot traded.


How does this apply to trading?

Borrowing and investing in different countries would be way too complicated for an individual to do alone. This is why we do business with brokers. They can give us access to trade almost all the currencies in the world. As we know the FX market operates in pair, meaning that if you invest in a currency you are implicitly borrowing another. To come back to our example, this would mean that we want to short the EUR\USD pair. Basically, this would equivalate to being long in the USD and short in the EUR.

The interest rates that is used to calculate the rollover is based on the different central banks reference rates which represents the rate that banks can borrow money overnight.

Naturally there is also some carry cost implied that is charged to the trader for all the overnight rollover manipulations. The good thing here is Dukascopy has one of the lowest carry cost in the industry. This rollover procedure is also known as ''swaps'' where the investor receives or pays the interest on each overnight position. I really recommend everyone to go on the public website of Dukascopy where they clearly explain the procedures on how the rollovers are calculated and at what time they are processed. They even have a tool that calculates what impact the rollover will have on your overnight position. This tool also helps you identify quickly if you should long or short the pair to have a positive carry position and which pairs have the biggest yield spreads.




What is the risk of a carry trade?

In short, the risk of this type of transaction is that your borrowed currency appreciates. In our example, if the Euro would appreciate 2% compared to the US Dollar our 1 lot trade would now be a losing trade of 250$ (1750$ - 2000$). Backing a bit more than 10 years ago, investors saw this risk ruin all their profits when the most popular carry trade at the time (Long AUD\JPY) lost almost 50% of its value with the 2007-2008 financial crisis.


When to use carry trades?

Knowing the risk I just mentioned, you cannot necessarily take for granted that the best and most profitable carry trades are the one that you borrow from the country with the lowest interest rates and invest in the country with the highest. In fact, basic economics tells us that a market should be efficient and so the price of any asset should reflect all information available to the public. The Forex being the largest and most liquid market, it is certainly not an exception to this theory. Thereby, the prices of currency pairs reflects the long-term situation of interest rates and thus the carry trade opportunities that are related to it. As a result, there is no arbitrage that can be made and you cannot rely on this aspect alone or else you might burn yourself.

However, if let's say you believe that the Japanese Yen will decrease in value and the Euro and USD should stay stable, you might want to prioritize a long position in USD\JPY rather than a long EUR\JPY. Thus, you will not only have your capital gain on your short position on the YEN, but also interest income.


Conclusion

Carry trades should be another tool in your toolbox and should never be traded and used as your sole indicator to get in a trade. While searching for trading opportunities, mainly swing-trades or long-term trades, you should always consider what is your cost of carrying the position overnight. This might change the pair you trade and earn you extra income revenue.
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