What is carry trade strategy?
In the simplest terms, the carry trade is where a trader borrows one financial instrument to buy another financial instrument. The carry trade is very popular in the Forex market. It is a situation when a trader borrows, or sells, one currency with a low-interest rate to purchase another currency with a higher interest rate.
The trader is paying a low-interest rate on the borrowed currency while collecting the return on the higher interest rate of the currency purchased. The difference is known as the interest rate differential.
How Forex carry trade works
The Forex market is the ideal place for carry trades as currencies are traded in pairs. For example, when you are buying the EUR/USD exchange rate you are buying the euro while simultaneously selling US dollars. Fortunately, you don’t need euros or dollars in your trading account as the broker will take care of any currency conversions behind the scenes to make the trade.
When trading Forex with a broker all positions are technically closed at the end of each day, even though the market is open 24 hours a day, 5 days a week. The broker will close and reopen your position and then either credit or debit you with the difference in the overnight interest rate of the currency you have sold and the currency you have bought. This is known as ‘rolling over’ or ‘carrying’ a position to the next day.
Risks of carry trades
There are risks associated when using a carry trade strategy. For example, the country with a low-interest rate has a low-interest rate for a reason. Typically, central banks will keep interest rates low when the economy is struggling to encourage consumers and businesses to borrow, spend and invest to increase economic activity. When the economy starts to grow again, the central bank may start to increase interest rates to stop it from overheating, thereby affecting any carry trade.