Differences between carry trade and arbitrage forex strategies

Carry trade and arbitrage are two of the most useful trading strategies used by forex traders. Sometimes, the former is considered as a particular type of the latter but their features make them quite stand-alone and diverse techniques.

More in details, the carry trade is a strategy which enables traders to make a profit even when the market is stable as it does not rely on market prices but rather on borrowing money from a low interest rate currency and to fund purchasing another currency that provides the investor a higher return. The advantage of this strategy is due to the possibility to capture the existing spread between two interest rates, which sometimes can be particularly relevant, depending on the amount of leverage used. Some currencies are more suitable to carry trade strategies than others. The Australian dollar/Japanese yen (AUD/JPY) and the New Zealand dollar/Japanese yen (NZD/JPY) are the most used examples of carry trade currencies, because, from an empirical point of view, the rate spreads of these pairs have always been high. In any case, a trader who wishes to follow a carry trade strategy has always to find out which currency currently offers a low yield and which one offers a high yield and then borrowing money from the former in order to purchase the latter.

Also arbitrage strategies rely on market price differences but in a broader sense. They are speculative strategies, where a trader gains from price discrepacies in currency pairs. A trader buys and sells currency prices that are divergent at the time he trades but extremely likely, at least according to empirical evidence, to rapidly converge. A trader’s expectation is based on the bet that, as currency pairs approach their mean, the arbitrage becomes more profitable and can be succesfully closed. Thanks to modern trading tools and technology, the operation can ben done sometimes even in milliseconds.

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