Forex Blog: Currency Trading News & Analysis.

June 25th 2008

The Carry Trade Explained

The Carry Trade is one of the simplest strategies in forex, and if executed correctly, can also be one of the most profitable. The basic mechanics of a carry trade involve borrowing in one currency that offers a low interest rate, and selling it in favor of a higher-yielding currency, in order to capture the interest rate spread. This strategy carries two key risks. The first risk is that the "long" currency will depreciate. This also includes country risk, the possibility that political or macroeconomic instability will adversely affect the long currency. Then, there is the risk that the interest rate differential will change such that the spread shrinks, and a smaller carry is earned. For a while, the most popular funding currency was the Japanese Yen, with its negative real interest rates. Now, however, the Dollar has become a popular funding currency, due to low interest rates and a self-fulfilling belief that it will continue to depreciate. It should be noted that there are variations to the carry trade, which may involve combinations of currencies and hedging. SeekingAlpha reports:

Another way of protecting against the downside is to write covered calls. Depending on the size of your investment and your risk preferences, either short selling or writing a covered call will let you sleep better.

Read More: The Burden of the Carry Trade

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Posted by Adam Kritzer | in Investing & Trading | No Comments »

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