Carry trading is one of the most famous forex strategies, which requires going long a ‘high-yield’ currency against a ‘low-yield’ one. The Japanese yen or the Swiss franc are commonly used as examples of ‘cheap currencies’ while emerging markets currencies as ‘expansive currencies’. The success of these strategies relies on many things, mainly timing interest rate cycles in a correct way and having the backdrop of a low volatility, ‘risk-on’ environment. Common mistakes made by carry traders are: chasing excessive spread, not to keep up on central bank monetary policies, choose a too high leverage, and lack of broader-level currency portfolio diversification.
Financial markets’ transactions are based on a borrower/lender relationship. The spread between borrowing and lending activity is the basis for achiving a correct pricing of financial assets. Every time a trader invests money, he is implicitly choosing a spread, as future returns on invested capital justify trading or investing activities.
Which are the “high yield” and “low yield” currencies? The answer is: it dependes on interest rates. These are chosen by central banks, which may hike or lower rates to achieve their macroeconomic goals (e.g. price stability, growth, employment levels) and which impact on currency pairs. AUDJPY and AUDCHF are typically the more popular carry trade pairs chosen by traders, with AUD being the “high yield” currency and JPY and CHF being “low yield” currencies. If a trader were to go long on the AUDJPY, he would earn an interest. If he were to go short, he would pay it.
Among the major 7 currencies, the benchmark overnight rates for each of them are currently as follows:
AUD – 1.50%
USD – 1.50%
CAD – 1.00%
GBP – 0.50%
EUR – 0.00%
JPY – -0.10%
CHF – -0.75%
The actual rates offered by a broker can differ from the spread obtained on trades as implied above. For example, while the above rate might suggest the annual carry from an AUDJPY trade is 1.60% (1.50% – -0.10%), the actual spread offered by a broker could be lower.
In today’s low interest rates financial environment, carry trades is no longer rewarding among major currency pairs as they were in the past. For this reason, many carry traders are now obliged to borrow in a cheap major currency to buy a higher-yielding emerging market currency, if he wants to earn a yield which is higher than that provided by higher-duration US Treasuries (considered as a benchmark safe yield). Nevertheless, the success of this operation is not always guaranteed.