What is the difference between a carry trade and a spot trade? Do they use the same underlying mechanism? My understanding is spot FX is a 2-day FX forward contract that has to be rolled (by your broker) if you want to keep it open. Does it roll after the 2nd day or is it every day? Is a carry trade just a spot trade that has been held for longer, with a different outlook/horizon, and probably larger size…?
In a carry trade a trader sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate and attempts to pocket the difference in interest rate as profit.
As an example a trader borrows 1’000 JPY from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount.
Let’s assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% as long as the exchange rate between the countries does not change.
It is also known as “playing the interest differential game”.
Spot trade is the purchase or sale of a foreign currency or commodity for immediate delivery. Spot trades are settled “on the spot”.
Your understanding of a typical trade in the spot forex market is correct. Regarding the rollover, it is done automatically by your broker every day, so that the “2-day forward contract” which you have entered into is always either one day, or two days, from expiration.
Typically, when the rollover occurs, you are [B]paid[/B] interest on the single currency which you purchased, and you are [B]charged[/B] interest on the single currency which you sold (because, in effect, you borrowed this currency from the broker, in order to sell it). The rate of interest in each case is determined by the official interest rates prevailing in the countries whose currencies you are buying and selling.
So, if you buy the USD/JPY, you will be paid interest based on the official U.S. interest rate, and you will be charged interest
based on the official Japanese interest rate.
A couple of years ago, when the U.S. interest rate was 5% or so, and the Japanese interest rate was zero, long positions in the USD/JPY produced positive interest income for traders holding these positions for days, weeks or months. When the USD/JPY was rising, primarily because of the weakness in the yen, this was a win-win for traders holding long USD/JPY positions: they made money on the rising value of the pair, and they made money every day on the interest differential.
That interest differential is commonly referred to as “positive carry”, and the trade itself (and any similar interest-rate trade)
is referred to as the [B]yen carry trade[/B].
You can get all this info, and more, from the Babypips School — you just have to do some digging. Here’s a link to the School lesson on Carry Trade: How the Carry Trade System Works in Forex Currency Trading.
And here’s a link to the same subject in Investopedia: Currency Carry Trade
(You will notice that Babypips offers a much better explanation!)
Clint
Yes it does 
I see now (I think), so you can do a carry trade in the FX spot market by taking a position in a single pair.
You can also do carry trades using non-FX techniques like taking a bank loan in one country and investing in another country (if you really wanted to), that there are different ways to do carry trades.
[B]Penhau,[/B]
Your summary is correct. Whenever you hear forex traders talk about the carry trade, you can assume that they are talking about [B]forex carry trades [/B](as in the USD/JPY example that I gave you).
Obviously, positive carry, by itself, is not a sufficient reason to take a position in the forex market: even when the interest differential is as large as 5%, positive carry will not generally offset a trade which is trending against you.
Rather, positive carry is a nice bonus, when it happens to coincide with a strong, long-term trend in a currency pair. And it can offset a little bit of the temporary loss associated with a retracement from that long-term trend.
I hope this clears things up for you.
Clint
Not to be greedy, but any situations like that at the moment?
With the ECB, Fed and the BoE all at 1% or lower (not to mention Sweden at the moment) there should be some potential here. You’ve got Australia and New Zealand at around 2.5-3% and places like Brasil, Russia, India and South Africa at anywhere between 8-13%.
This will obviously be a fundamental analysis question, but do you reckon a long play on any of the above will be worth it just for the carry trade? Or are these currencies (referring to the latter now) just too volatile?
How about China? Their currency is pegged to the dollar (with a few slips every so often), so hardly any movement there and their interest rate is about 5% more than the US.
shaforex,
[B]First point:[/B] Your question implies going at this thing backwards. You shouldn’t start out by identifying currency pairs with large interest rate differentials, and then try to find a justification for trading those pairs. If you do that, you will likely talk yourself into a questionable trade just so you can collect an interest payment. If the trade is questionable, it most likely will eat up all your interest payments, and then some.
Instead, if you are comfortable holding long-term positions in the currency market, then you should look for trades with the potential for significant multi-month moves. When you identify such a trade, part of your evaluation of that trade would be to estimate the carry. The estimated carry may be positive, providing a small daily profit on an automatic basis; or, it may be negative, in which case the daily interest which you have to pay will diminish the profit, or add to the loss, in that position.
If a long-term trade looks good to you on its techinical and fundamental merits, and also has a positive carry, then that trade offers a nice bonus. But first, be sure the trade makes sense on its merits (technical and fundamental), without getting excited over the positive carry.
If position trades, or long-term swing trades, suit your trading style, then carry trades can be a fun way to make a few bucks on the side.
[B]Second point:[/B] Unless you are a very experienced trader, you should stick with the major currency pairs and the major currency crosses; and you should stay away from the minor currencies (with the exception of the NZD) and from ALL of the exotic currencies.
The major currencies are USD, EUR, JPY, GBP, CHF, AUD and CAD (listed in order according to worldwide trading volume)
The major currency pairs are: EUR/USD, USD/JPY, GBP/USD, AUD/USD, USD/CHF, and USD/CAD (listed in order by trading volume)
The major crosses are: any combination of EUR, JPY, GBP, AUD, CHF, and CAD (not involving the USD).
Minor currencies are: SEK, HKD, NOK, NZD, MXN, SGD, KRW, ZAR, and DKK (listed in order by trading volume)
Exotic currencies are everything else, including the rouble, the yuan and a couple of others that you mentioned.
Clint
Very good point, Clint, thanks. That’s something I need to keep in mind for all trades, I suppose.
Going back to the Chinese Yuan: I understand that it is an exotic currency, which probably also means that just the spread will eat out any gains I may or may not get right from the start. But as it’s pegged to the USD, and in the last who-knows-how-many years has only appreciated, it is very likely that it will continue in that direction. So going long on the CNY should be an easy decision to make: CNY going up against the USD and positive interest rate differential.
Not so?
shaforex,
You’re correct on the interest rate differential, but your theory about perpetual appreciation of the CNY against the USD is wrong.
First, regarding interest rates, the official Chinese rate is currently 5.31%, and the official U.S. rate is currently 0.25%. Let’s say your broker actually paid or charged these official rates. Then, if you hold a short USD/CNY position, you will be paid 5.31% and you will be charged 0.25% on the value of your position, because you have bought yuan and sold dollars. So far, so good.
Second, regarding the trend of the USD/CNY, for a number of years, the pair was trending downward, so if you were trading it, you would want to be short the pair. But, look at the past 13 months — the price of the pair has been very nearly dead flat.
Here are a couple of charts:
If you are confident that the USD/CNY will remain flat, then this trade might make sense as a pure interest-rate play.
If the down-trend were to resume, then this trade would qualify as a true carry-trade.
If I were considering this trade, I would want to know what happened in July 2008 to abruptly end the trend in the USD/CNY.
And I would want to be sure that liquidity problems would not prevent me from getting out of this trade quickly, if an adverse trend, or unacceptable volatility, or an adverse change in the interest rate differential, should occur.
And, of course, I would have to have an account with a broker who offers this pair. As of now, I don’t have access to this currency pair: neither FXCM (with their Trading Station platform), nor Alpari (with their MT4 platform) offer the USD/CNY.
Maybe Saxo Bank has this pair (the monthly chart, above, is from Saxo Bank).
Finally, your concern about the spread is unfounded. The whole idea of a carry-trade is “buy and hold”. So, you pay the spread once; and compared to the potential trading gains and the interest gains from a good carry-trade, the cost of the spread is negligible.
Go back to a chart of the USD/JPY from April 1995 until about October 1998 for a look at the mother-of-all-carry-trades:
5,000 pips gained plus a positive interest differential.
Let us know if you actually do this dollar-yuan trade.
Clint
p.s. - for anyone who’s interested, here is a table of world interest rates: World Interest Rates Table
As far as I’m aware (and really I have no professional background or knowledge), but Bush and the US State department were quite strong on the Chinese government’s back about the peg to the dollar, how it undervalues the yuan, cheap chinese exports, US economy suffering due to it, how it’s unfair, etc etc etc. I think they were threatening various sanctions and so the Chinese decided as a ‘goodwill measure’ over time to slowly change the peg from what was essentially CNY 8 to what it is now, just under 6 (just over 25%). These things are always very secretive, though, so no one knew how much it will go down or when it’ll stop (or start back up).
I wouldn’t be at all surprised if the credit crunch meant the US was more concerned with its own economy than with influencing others’, and I certainly don’t know what Obama’s thoughts on the matter are. I also wouldn’t be at all surprised if they were doing this to show how compliant they are with the West, what with the Beijing olympics, and once that was over they had nothing else to prove and no motivation to continue to hurt themselves economically.
I doubt it would move much in the near future. Maybe when things pick up again and it’ll be more ‘business as usual’ around the world, we might see more pressure put on the Chinese and their currency. But over the long run, it’ll either be stagnant as it is now (and has been for considerable periods in the past) or continue the downtrend. Mind you, they might change the peg from USD to a basket of currencies or a mix of USD and EUR, which will throw this whole thing out’a whack.
Of course none of the above is expert opinion. My views only. DYOR.
I don’t think I’ll be putting in this trade because when I start to trade with real money (still a long way from now), I don’t think I’ll have access to that pair either. It’ll have to go down as another one of those things I really wanted to do but never did, just like buying Google shares when they first listed. :o
I could have used that table when I wrote my previous post!!
The biggest cries for the Chinese government to appreciate their currency came when the US trade deficit was at its largest. An easy target for politicians to blame on job losses. Now with the trade deficit decreasing, it gives China cover to slow down the appreciation of the Yuan to help with exports.
I’ve had friends try carry trades in exotic currencies such as the Turkish Lira or South African Rand, but just be careful lest we forget what happened to Iceland and how that carry trade blew up.
I see some pretty big base rate differences between countries, e.g., Russia, Brazil vs a lot of others, assuming you took on these trades. There inflation rates are pretty huge though too. All else being equal do inflation rates have any effect on interest rate differentials in FX carry trades? What about GDP?
Hard to say ‘all else being equal’, because in an ideal world currencies should move towards interest rate parity, so that borrowing in one country to deposit the money in another has a zero net benefit. And likewise with inflation - as it erodes the buying power of your money the effect on the currencies should quickly balance it out.
But apparently, things don’t work out so predictably! Funny old world we live in…
Sorry, Penhau. Completely misread your post, mate. I thought you were referring to the currency movements rather than the effect on the interest rate differentials.
I probably won’t be the best person to ask about it since I haven’t even started trading, but I think the interest rates that you pay/receive depend on the rates your broker gets for borrowing and depositing the money. It should be pretty similar to the base rates of the countries involved, but with a slight margin (up for borrowing and down for depositing). I don’t think inflation or GDP will affect the rates.
But please someone with experience, can you confirm this?