For the past few years, probably the most popular currency trading strategy is that known as the Carry Trade. Traders feel they are acting as banks, keeping the interest rate differentials by paying out lower interest rates (Borrowing) and bringing in money through higher interest rates (Lending). The best part about this type of trade is that you not only keep the interest rate differential, but you can also leverage that interest rate differential to create a pseudo-residual dividend payment.
The basic premise behind the carry trade is that in any FOREX transaction you are simultaneously selling one currency and buying another; therefore, you are simultaneously borrowing at one interest rate and investing at another interest rate. For example, we want to go long the US Dollar and short the Japanese Yen (a popular currency to short in a carry trade). We are, in fact, able to borrow our Yen at .8% and we are able to invest in US Dollar at 4.925%; thus, we are able to keep the interest rate differential of 4.125%. But the carry trade doesn’t just stop at the 4.125%. Because FOREX brokers offer retail investors leverage, traders can leverage that interest rate spread many more times; however, at the same time, they are exponentially adding to their risk.
For instance, if I had a $10,000 account balance and I was looking at buying the US Dollar and selling the Yen, I could potentially invest up to 50 times my account balance. With such a leverage, I would get a margin call very quickly if that trade turned against me. Continuing with this example, let’s say that I go long 50,000 units of the USD/JPY, meaning that I am leveraged 5 times, I would make $2,065.86 in interest a year from this trade (or 20.66%), with a margin call limit of 98.03, when the USD/JPY is currently trading at approximately 116. While this may sound good, if the trade were to all of a sudden go against me, and the Yen started to appreciate or the US Dollar started to depreciate or both, I could potentially be exposed to risk which is now multiplied by the leverage percentage. Thus, if the USD/JPY fell 10%, you would lose about 50% of your investment when leveraged 5 times.
That brings me to my next example of a carry trade—one that doesn’t really need to be leveraged, but could be if you are willing to take on the risk. Even leveraging this carry trade 2 times would yield a 34% return via interest payments + or - any currency movements. The trade I am talking about involves the Turkish Lira (TRY), which currently has an interest rate near 17% in a much improved economic situation. With that type of interest rate, you are able to borrow at lower, more reasonable rates and invest at a much higher rate. Although investing in an exotic/emerging currency is much higher risk, this type of interest rate spread gives you at most roughly a 17% (minus the interest rate in which you borrowed) cushion against either the Lira depreciating by 17% or another currency against the Lira appreciating by 17%.
An interesting trade that I have noticed is that of Long TRY (Turkish Lira) and Short CNY (Chinese Yuan). You may be wondering why in the world I would take a short position against a currency that is being appreciated artificially by its government and carries a current domestic interest rate around 6%. However, at Oanda.com where I have my FOREX brokers account, they have the interest rate set to -1%; since it would be a popular long position, they have set it up to encourage people to short the currency because of its long-term attractive Long investment. Basically, the idea with the New Turkish Lira and the Chinese Yuan is that I would be paid 18% in interest payments a year (17% from the Turkish Lira + 1% from the Yuan Short) and if the investment is leveraged 2 times, it will make 36% a year in just interest income. The other good news about this trade is that it has been relatively stable, despite one pretty noticeable fall of roughly 20% in the Lira from May 2006 to June 2006. The fall followed a steady appreciation of the Turkish Lira due to the carry trade, and the massive sell off was mainly due to speculators and hedge funds artificially manipulating the market. Even with the 20% drop, there was still the cushion of the 18% interest rate differential to help protect the downside.
The idea here is that if I had a $10,000 account balance and I decided that I wanted to invest 2 times that amount ($20,000) into the Long TRY/Short CNY trade, I would be making $9.56 a day from this position (interest is paid 365 days a year), or $3,489.91 a year in interest on my $10,000 investment. Plus, with my account, I am being paid a rate of 4.925%, which is approximately $1.35 in interest a day, or a total of $492.50 in interest payments a year. The account would be receiving about $3,982.41 a year in interest payments, for a total return of 39.82% a year, which one should consider a terrific return on investment. This is a fairly conservative trade; many people would leverage it much higher. This would increase the risk, though, which I don’t find completely necessary when an investment with minimal risk has such good returns. You can play around with different investment amounts and the interest that you can expect to receive using the Oanda Interest Calculator.
Here is the graph of the TRY/CNY since Turkey had introduced the New Turkish Lira:
And another graph of the TRY/CNY showing the drop in May to June 2006:
And lastly, a graph of the TRY/CNY over the past 6 months and the relative stability:
I think what the last few months show that, perhaps, the Chinese are seeing the opportunities of being able to invest into an economy that is exhibiting such a high interest rate, thus the Chinese may be selling their Yuan currency holdings and purchasing Turkish Lira to either make investments in their stock market or into their fixed income investments. Overall, I think that an 18% interest rate is very well worth the risk of making a bet on the direction of two emerging economies. Other possibilities of carry trades can include the ultimate carry trade currency, the Brazilian Real, which has an interest rate of over 15% and has been steadily appreciating against all currencies, with little retracement.Conclusion:Remember there are two key components of a carry trade, and these are the same as investing into dividend paying stocks. The income is nice and can provide a nice downside cushion, but you also have to make an informed decision on the direction of the currency (stock) in the hopes of it appreciating in value (or at least depreciating less than the interest rate cushion).
I find the opportunities in currencies to be very fascinating, so please look forward to further communications in regards to other strategies that I find to be relatively profitable.
This analysis does not take into account spread costs and taxes. If you should have any questions, please feel free to comment below.
