I am still missing something obvious about the carry trade, and I’m hoping that this post may be quicker than doing my own research. I believe my misunderstanding revolves around pip conversion, but I’m not sure.
I understand the carry trade to be a purchase (long) of a high interest yielding currency and the selling (short) of a lower interest yielding currency in the anticipation of yielding the difference in interest.
My confusion arises because I’m not seeing how a carry trade loses money. Here is where I make my mistake, so I’m hoping someone can provide a numerical explanation for my naivete.
Suppose I’m long AUD/JPY 1 lot and short AUD/JPY 1 lot. I’m wrongly assuming that any gain in my long will be offset in my short. Obviously, this is incorrect. But why?
I’m looking for a numerical explanation for the drawdown, so please don’t just give me the textbook explanation of a carry trade (I’m more than familiar with that)
Considering you’re hedging using the same exact pair, it’s obvious you’re losing money (because of spread). In order to get a viable carry, you need to sell off a currency with a low interest rate and purchase one with a high interest rate. So, you’re looking to sell a low-interest currency (jpy), and use that to buy a high-interest currency (aud): audjpy. Because AUD is the base currency, that would mean you’re buying the aud and selling the jpy. You would need to go long AUDJPY to get a positive carry.
-Edit-
Whenever you’re looking to place a carry trade, just remember that you want the higher-interest currency as the base currency when going [B]long[/B]. If you went short audjpy, you would be selling off the aud in return for jpy, meaning you would get a negative carry difference (i.e. lose money)
What you did is equivalent to hedging: the carry interest gained from the long is offset by the short and you also lost money because of spread.
I think what I missed was that the carry trade only involved one position. The interest that accrues is already the difference between the yields of the paired currencies.
I erred because I was assuming that it involved two positions and that the long position paid positive interest while the short position had a negative interest.
So now I can easily see why the carry trade has a large drawdown and can lose money. It’s basically just going long in a high yielding currency and praying that it doesn’t drop a greater percentage than the interest differential.
The example given in the school is slightly confusing because it seems to indicate that you need to have two positions.
Carry trades aren’t worth the time atm, till the world raises thier interest rates, not expecting that anytime soon… unless your willing to risk osbcure currencies