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In yesterday’s top currency news, we discussed how major banks can see the yen carry trade coming back.

A Carry Trade is simply an investment strategy where one borrows an asset at one interest rate, sells the asset, then invests those funds into a different asset that generates a higher interest rate yield. Profit is acquired by the difference between the cost of the borrowed asset and the yield on the purchased asset.

Though most currency traders have the notion that it only applies to the forex market, in actual fact, it is played out everyday in our lives. For example banks borrow cheap (at the low overnight rate, i.e., the rate at which they pay depositors) and lend expensive (at the long-term rate).The annoying thing about this scenario is that they tend to lend to the depositor. The bank borrows from the depositor at say 3% or from the intra bank market, and gives out a car loan to the same depositor at 6% , making 3% .

Since the Bank of Japan reduced their interest rates to 0% , the yen carry trade is the most popular form of this strategy. Put simply, the yen carry trade is borrowing at low interest rates in yen and using the loan to buy higher yielding assets elsewhere.

In the Carry Trade, speculators buy high interest currencies and sell currencies with low interest rates. These positions ensure that each trading day rollover-interest will be posted to the trader’s account. Thus the Carry Trade has the potential to significantly enhance a trader’s return.

Perhaps the most popular form of the strategy exploits the gap between US and Japanese yields. Anyone borrowing for next to nothing in yen and putting the money into US Treasuries (US government bonds) has received a double pay-off: from an interest rate difference of more than three percentage points and from the dollar’s rise against the yen. Investors make their profit when they reverse the trade and pay back the yen loan.

For example, a trader borrows 1,000 yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Assuming the bond pays 4.5% and the Japanese interest rate is set at 0%,[4] the trader stands to make a profit of 4.5% (i.e. 4.5% – 0%), as long as the exchange rate between the countries does not change. Leverage can make this type of trade very profitable. If the trader above uses a leverage factor of 10:1, then he/she can stand to make a profit of 45% (i.e. 4.5% * 10). However, if the U.S. dollar were to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Furthermore, because of the leverage, small movements in exchange rates can magnify these losses immensely unless hedged appropriately.

For the forex trader, the most fundamentals that one really needs to know is the interest rates for each pair one is trading. To become a successful carry trader, understanding the role that interest rates play in the FX market is a crucial task. A country offering high interest rates will attract more capital as investors seek to capitalize higher returns. As interest rates rise, investment will follow, which can in turn increase the value of the currency. Carry trader’s main focus becomes the expectation on the direction of a country’s interest rate, to ensure their high rate of return.

We shall be discussing later in the carry trade series specific examples on how to set up a carry trade.

Trading Forex with Fractals