This is a guest post by Ahmad Hassam
Carry trade strategy entails buying a high interest rate currency and selling a low interest rate currency. Suppose, New Zealand Dollar NZD offers an interest rate of 4.35% while the Japanese Yen JPY offers 0.35%. Carry trade strategy involves buying NZD and selling JPY. The investor earns a profit equal to the interest rate differential of 4% as long as the exchange rate between the two currencies does not change.
Carry trade is one of the fundamental trading strategies that uses the basic economic principle that money constantly keeps on flowing from a low interest market to a high interest market. Markets that offer the highest interest rate attract the most capital. Countries are no different. Countries offering a better interest rate attract more capital as compared to countries offering low interest rate.
In order to profit from carry trading strategy, you need to understand how it works. An investor in Japan will get only an interest rate of 0.35% on her deposit. She might want to earn a much higher interest rate. When she discovers New Zealand offering 4.35% interest rate on NZD bank deposits, she transfers her JPY deposit into a NZD deposit by selling JPY and buying NZD.
When millions of depositors will do the same thing, capital will flow from Japan into New Zealand. The inflow of capital will appreciate NZD and the outflow of capital will depreciate JPY. This will further add to the profits of a carry trader. Now, carry trade works when investors have low risk aversion. So, carry trade strategy works when investors as a group are willing to take the risk of investing in a high yield currency. However, during times of high risk aversion, carry trade strategy fails. During times of high risk aversion, capital will start flowing in the reverse direction as investors try to seek safe haven currencies.
Now, if you use leverage in carry trading, the profit multiplies. Leveraged carry trade is a popular trading strategy used by the hedge funds. Suppose, you use a leverage of 5:1, the interest rate differential of 4% becomes 20% giving you substantial profits. Increase leverage to 10:1, your profit will soar to 40%.
But, as always using leverage is a risky strategy. It can multiply your profits when the market is cooperating with you while it can substantially multiply your losses if the market refuses to cooperate and suddenly turns against you.
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