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Your Money > Investing Ideas Articles > The carry trade
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By Betsy Waters, global head of dbFX.com
There is a method to the seeming madness. Despite the fast paced, open-all-hours, seemingly opportunistic culture of the foreign exchange (FX) markets, there are three defined strategies used by traders when investing: the carry trade, the momentum trade, and the fundamental trade. If you know anything about the art of currency trading you've probably heard of the 'carry trade,' which for much of the past five years or so has been synonymous with any mainstream discussion about forex. The strategy - where an investor generates income from the interest rate differential between two currencies - has been by far the most popular trade in recent times, with as much as 50 per cent of all trades involving the strategy. How the carry trade works Quite simply, investors borrow from a low yielding currency and invest in a high yielding one, and earn income from the interest rate differential between the two. The most obvious, and most commonly used, example over the past two to three years that brings this strategy into context involves the Japanese Yen and the New Zealand Dollar. For many years, Japanese interest rates have been close to 0 per cent, whereas New Zealand - which traditionally has higher interest rates than other countries because it loans capital to lend to its own economy from other central banks - has, until recently, had interest rates as high as 8 per cent. In this scenario, investors have been able to borrow Yen at close to nothing and invest it in a high interest earning currency, in this case the New Zealand dollar - thereby providing investors with the opportunity to earn significant yield on the interest rate differential. Of course, it's not as simple as all that, and in the real world valuations between two currencies (known as a currency pair) fluctuate according to supply and demand, and an overvalued currency can make a 'carry trade' less effective. Investors also need to keep a close eye on the interest rate movements of central banks, which ultimately provide the yield which makes the carry trade so attractive. Recent trading figures from dbFX.com show that in 2007 the carry trade made up over 35 per cent of all trades on the platform, with a reduction to 25 per cent in 2008. In January 2009, the carry made up 12 per cent of all trades on the platform, reflecting the decreasing interest by investors in the strategy. Considering its success in the past, the question is: why the significant drop in the number of carry trades being executed, and why now? The looming recession has certainly played a large part in the demise of the carry trade as an effective trading strategy. Central banks around the world, including the likes of Australia and New Zealand, have been consistently reducing interest rates to stimulate flailing economies, and this has reduced yields significantly - making these currencies less appealing to the carry investors. As a result, investors have shifted their focus and are looking at other strategies such as momentum and fundamental trades to generate returns - strategies we'll give additional insight to in the coming weeks. Useful links: | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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