This is a guest post by Andriy Moraru
The carry trade is a special kind of position (long term) trade in Forex. The idea is to locate a currency pair with a high differential in interest rate which preferably is trending in the appropriate direction, and purchase the currency with the high interest rate and sell the currency with the low interest rate. You want the currency you’re purchasing to be trending bullish. Then you wait, and accumulate profits, and eventually, you get out. And that’s about it.
As an example, we’ll take the classic GBP/JPY carry trade. The GBP/JPY was a very popular carry trade for many years. As a matter of fact, just about any pair which involved selling the JPY was a popular carry trade because of the Yen’s low interest rate.
Investors in the GBP/JPY carry trade bought the Pound (which has a high interest rate), and sold the Yen (which had a very low interest rate). When you buy and sell a currency pair like this, you are technically borrowing the value to purchase the Pound by selling the Yen. That means you pay interest on the currency you are selling/borrowing, just as you would if you took out a bank loan. So you would’ve paid the low interest rate on the Yen. Simultaneously, the broker would’ve paid you the high interest rate on the Pound!
To compound the profits, the GBP/JPY was trending upward for a long time. So on top of your profits from the interest, you also would’ve been accumulating all those pips from the upward price movement by buying low and selling high.
As you might imagine, this worked fantastically for many years for a lot of currency traders. The carry trade was low maintenance, high yield, and reliable. It was also based on fundamental analysis, and fundamental assumptions. It was a sensible trade, but a lot of folks put all their eggs in one basket, and had all their money wrapped up in this one trade! And that meant that one day things went very, very badly for those people.
The carry trade is a reliable long term strategy, but it is not without risks. In the case of the GBP/JPY and other /JPY carry trade pairs, one day in 2008, the carry trade “blew up” in the faces of its many investors. Suddenly the pair reversed violently and swung back clear in the other direction. In a matter of hours, years of profits were erased. Many traders received margin calls. These traders had invested everything. They hadn’t moved their stops (although in situations that volatile, that might not have saved everyone; Forex brokerage limitations can result in slippage). They hadn’t been taking out their profits and moving them elsewhere. They took the carry trade for granted. They lost it all.
So what happened? Most people probably remember that the economic recession moved into full swing in 2008. While 2007 carried hints of it, it was in 2008 that the oil prices shot through the roof and so did unemployment rates in many places. What caused this phenomenon is believed by most economists to have been an increase in credit defaults worldwide (much of it in the US) which caused a loss of confidence in the credit markets. This is known as a credit crisis or credit crunch. Meanwhile the Yen was appreciating, and a lot of people started converting their foreign assets into Yen, causing the appreciating to soar. This resulted in the reversal, which is believed to have even further contributed to the recession. Meanwhile, a lot of people lost money in the carry trade.
The theory of the carry trade remains sound. The lesson here is that while most of the large movements in the currency market are gradual, sometimes world events can cause rapid, violent changes. Forex trading is a risky business, and a responsible person will understand that no trading strategy, however reliable, is invulnerable. You need to do what you can to protect your profits and spread out your risk. Nor do you have to abandon the carry trade just because of what happened—it’s still a good strategy if you manage your money responsibly. It’s the context that has changed. Just never, ever take anything for granted in Forex!