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Carry trade on EURUSD

Posted on by Emanuele Canegrati

The carry trade takes advantage of the difference in interest rates between currencies. It is a long-term strategy which involves going long on a currency with a higher interest rate and going short a currency with a lower interest rate. The higher interest rate currency is the invested currency, while the lower interest rate currency is the funding currency.

In ForEx markets, a trader simultaneously buys one currency and sell another currency. Every currency is related to an interest rate, set by its central bank. Depending on how a trader is positioned, he’ll either have to pay an interest rate or earn an interest rate. The interest payment occurs at the end of every business day at 5:00 PM EST, which is when funds roll over.
The carry trade looks to capture the variation in interest rate. A trader looks at pair selection driven by the interest rate spread. Investors borrow cheap money (i.e. currencies which carry low interest rate) and transfer it on another currency where  they’re paid with a high return on investment.
When a trader is long a currency with a higher interest rate, and short a currency with a lower interest rate, the trader will earn a positive carry. On the other hand, if you hold a currency with a lower interest rate, and you’re short a currency with a higher interest rate, you’ll have a negative carry. In this case, you have to pay the interest rate differential.

Let’s analysis a real case. Currently, the US interest rate set by the Federal Reserve is 2,5%, while the interest rate set by the European Central Bank is zero. The daily interest is calculated in the following way: (Interest Rate of the Currency that you are Long – Interest Rate of the Currency that you are Short) x Notional of Your Position

# of Days in a Year

For 1 lot of USDEUR that has a notional of 100,000, we compute interest the following way:

(0.025 – 0.000) x 100,000 = approximately $6.8 a day
365

Carry trade is succesful when the currency pair either does to not change in value or appreciate. When interest rates decrease, traders are less compelled to go long the currency pair and are more likely to look elsewhere for more profitable opportunities.