The carry trade in Forex markets

The term Carry Trade indicates those operations in the forex markets that exploit the differences between interest rates by borrowing money in those markets where it costs less – and therefore the rates are lower – and employing it where higher rates allow returns conspicuous. The return of the debt resources with a lower interest rate makes it possible to make a profit on the differences between the various markets. The use of financial leverage makes it possible to multiply the returns on operations, but also increases the risks taken by traders. For this reason, in the forex markets, solid currencies are often chosen to avoid excessive volatility. To avoid the particular risks of assets that are not liquid or have a different risk profile than that of the reference country system, carry traders tend to operate mainly (but not exclusively) in public debt securities.

Carry trade is a fundamental mechanism for understanding the dynamics that drive global financial flows. Strictly influenced by countries’ macroeconomic data and by the variations in interest rates regulated by central banks, the carry trade often returns an accurate image of the perceptions of the markets and the adjustment mechanisms that regulate them.

Some examples can clarify the close link between current events and carry trade mechanisms. The United Kingdom currently has an interest rate of 0.75%, while Turkey has interest rates of 24.0%. The difference in the cost of money can be used by borrowing in pounds, at a cost of 0.75%, and by investing in Turkish lira, that pays interest rates of 24.0%. After obtaining a 24.0% interest, you can repay your debts in pounds and earn accordingly. The leverage effect makes it possible to multiply returns (and risks) by moving the multiples of one’s own capital on the market.

A cut in interest rates by the Turkish central bank can, however, put this strategy at risk: in this case, the increase in the price of bonds in circulation increases the returns by benefiting the carry traders who have them in the portfolio, but lower yields of newly issued bonds reduces the margins for those who want to apply the same strategy with the new Turkish debt securities. For this reason, traders look for the most stable exchange rates, the most reliable currencies and make frequent use of stop losses.