A carry trade is a strategy in which an investor will borrow money from a low-interest-rate environment to fund a high-interest rate investment.
The main components of the carry trade are:
- Buying higher-yielding currency pairs
- Borrowing lower-yielding currency pairs
- Holding the position for a specific amount of time to benefit from any fluctuation in prices.
How Can You Use a Carry Trade in Forex Trading?
Identify the Higher-Yielding Currency Pair
When investing in the AUD/USD using a carry trade, it is essential to determine whether you want short-term or long-term capital growth.
If you’re only looking to invest for one month or less, consider buying USD/AUD if the current AUD/USD exchange rate is .8450 and selling AUD/USD at .8500. This could potentially provide an extra 3% profit per month on the capital gain alone; however, this excludes any interest received from borrowing money.
If you choose to use the carry trade for a more extended period, consider buying the AUD/USD at .8450 and selling it at .8500 long term. Although this will not provide an immediate cash flow advantage, it will potentially reap great rewards over time due to interest earned from borrowing money.
Identify Your Interest Rate
While determining whether you are looking to invest short-term or long-term is essential in judging your pair, it is equally as vital to know what interest rate you are willing to hand over your money to borrow. Brokers may offer two types of interest rates, both of which can affect how much return you get on your investment:
- Deposit Rates: The interest rates will be earned on any money in your personal savings account. These are generally lower than the interest rate you would receive if you borrow money from a bank.
- Borrowing Interest Rates: These rates will be higher than deposit rates and can be identified by looking at any financial information provided by the Reserve Bank of Australia (RBA). Ideally, it would help if you looked for borrowing interest rates close to or above 5%; however, this is entirely based on how successful you will manage risk.
Identify Your Risk Tolerance
A carry trade is only beneficial if there’s a positive gain at the end of your investment period. To ensure you can make money from this strategy, you must understand your tolerance to risk and which direction you think prices will move.
For example, if you believe the AUD/USD may increase from .8450 to a rate double that within three months, it would be wise not to use a carry trade. There will be no point in borrowing money with a higher interest rate if both currencies equal out. However, if you expect the exchange rates to remain constant within +/- 0.000025%, then a carry-trade would still provide a positive return.
Lend Your Money to the Bank
You will want to lend money either from yourself or your bank based on your interest rate. Lending money to yourself is far less risky as it is identified as an investment rather than a borrowing risk.
If you are lending money through your bank, however, some additional factors need to be considered before doing so:
- Fees: There may be fees for adding or withdrawing funds into/out of the account, including small administration fees, hefty withdrawal fees, and holding periods where no interest is earned until specific criteria have been met.
- Risks: As you are borrowing money from the bank rather than just investing in a currency pair, there are risks that interest rates may rise within the time frame chosen (thereby affecting both your returns and losses). There is also a risk in terms of whether or not you’ll be able to pay back the money when it’s due.
Hedge Your Position
After taking all necessary precautions, your security needs to make sure that if the AUD/USD falls in value or interest rates increase beyond what was initially planned, you will still be able to pay back your loan.
Hedging refers to the process of using futures contracts and options contracts to reduce risk. If hedging is too costly or impossible, I strongly recommend doing this step before lending your money to the bank.
Now that you know how, why not try using a carry trade in forex trading with Saxo Bank.