Carry Trading Strategy
Carry trading is a strategy that many investors use to profit from the interest rate differential between two currencies. Suppose, Japanese Yen (JPY) deposits give only 0.35% interest while the New Zealand Dollar (NZD) deposits give a much higher interest of 4.35%. By selling JPY and buying NZD, investors can profit from the interest rate differential of 4% between the two currencies.
Carry trade is one of the fundamental trading strategies that uses one of the basic economic principles 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.
Investing in high yield assets is what every investor wants. When a Japanese saver finds that she can get a much higher return of 4.35% on the NZD deposit as compared to getting only 0.35% on her JPY deposit, she will sell JPY and buy 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.
If you use leverage, you can multiply the interest rate differential with the multiple of the leverage that you decide to use. For example, by using a leverage of 5:1, you can multiply the interest rate differential of 4% into 20%. Not bad, huh!
But, you need to remember that using leverage is a risky business and it is a double edged sword that cuts both ways. When things work well, your profits multiplies by using leverage. But when things don't work well and market takes a turn, your losses also multiply. So before, using leverage you should think twice!
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