How to Use Murray Math Levels in Trading
Carry trade is one of the ancient and most popular currency speculation strategies. It is motivated by the failure of uncovered interest parity (UIP). Carry trade is a mechanism whereby traders from almost Zero interest rate countries would invest in high-interest rate countries to get more income.
Carry Trade Strategy
Carry trade strategy involves the borrowing of low-interest-rate currencies and lending high-interest rate currencies. Carry traders are of two types: investments carry (is a mechanism through which you would invest countries), and Liability carry (is the mechanism through which you take out your funds from that country).
Carry trading is one of the most straightforward strategies for (FX) currency trading that exists.
For example, if the pound (GBP) has a 5% interest rate and the US Dollar (USD) has a 2% interest rate, and you buy or go long on the GBP/USD, you are making carry trade. For every day that you have that trade on the market, the broker is going to pay you the difference between the interest rates of those two currencies, which would be 3%. This interest rate difference can build up over time.
The higher yield currency is referred to as the target currency, while the lower-yielding currency is referred to as the funding currency.
In the table above, what you are mostly doing is borrowing the USD (funding currency) to purchase/lend the GBP (target currency). For the USD, you are paying a low-interest rate and receiving a high-interest rate for lending out the GBP.
The key to carry trade is finding an opportunity where interest rate volatility was higher than the exchange rate’s volatility. Traders do this to reduce the risk of loss and create the “carry” with monetary policy becoming intensified. There is a reduction in opportunities; this does not, however, mean that there aren’t any opportunities.
Yen Carry Trade
Since the 1990s, the Japanese Yen has been the most cited currency as the funding currency, and this is due to Japan’s low-interest rate and relatively stable economy.
The carry trade is an interest rate arbitrage that involves borrowing capital from a country with low-interest rates and lending it in a country with high-interest rates. These trades can be either covered or uncovered in nature and have been blamed for significant currency movements in one direction or the other as a result, particularly in countries like Japan.
Over the years, the Japanese yen has been extensively used for these purposes due to the country’s low-interest rates. In fact, by the end of 2007, it was estimated that around $1 trillion was staked on the yen carry trades. Traders would borrow yen and invest in higher-yielding assets like the USD, subprime loans, emerging market, debt, and similar asset classes until the collapse.
The phrase “carry trade unwind” is a nightmare to a carry trader. A carry trade unwinds a global capitulation out of a carry trade that causes the funding currency to strengthen aggressively. This was seen with the Japanese yen during the great financial crisis (GFC).
Forex carry trade
There are two main components to the forex carry trade:
- Changes in interest rates: the central element of the carry trade is centered around the interest rate differential between two traded currencies. Even if the exchange rate between the two currencies remains constant, the trader will profit from the overnight interest payment. However, over time, the central bank deems it necessary to alter interest rates, and this poses a high potential risk to the carry trade strategy;
- Exchange rate appreciation or depreciation: the other component of the carry trade strategy focuses on the exchange rate of the two currencies. Traders will naturally look forward to the target currency to appreciate (increase in value) when long. When this happens, the payoff to the trader includes the daily interest payment and any unrealized profit from the currency. However, the profit the trader sees, as a result of the target currency appreciating will only be realized when the trader closes the trade. However, a trader can lose money when the target currency fails to appreciate but instead depreciates against the funding currency so that the capital depreciation wipes out the positive interest payments.
As obtainable in any trading strategy, there is a risk to the carry trading strategy. The currency pairs that have the best conditions for using the carry trading method tend to be very volatile. For this reason, carry trading must be conducted with caution, bearing all the risks in mind. Nervous markets can have a fast and massive effect on currency pairs that are considered to be “carry pairs,” and without proper risk management, traders can be drained by a surprising and brutal turn.
Dollar Carry Trade
The most frequently used carry trade has involved currency pairs like the Australian dollar/Japanese yen and New Zealand dollar/Japanese. An example of currency carry trade, assuming the Australian official cash rate is currently at 4% and the Japanese yen yields 0%, a trader may decide to take a long trade on AUD/JPY if the pair is likely to swing high. Traders looking to capitalize on the interest rate differential will undoubtedly be borrowing Yen at the much lower rate and receiving the higher interest rate associated with the Australian dollar. In reality, retail traders will receive less than 4% interest rate as forex brokers usually apply a spread.
Conclusion
The carry trade is when you are essentially borrowing the funding currency with a low-interest rate and using that currency to buy a higher interest rate currency and merely profiting from the difference of the interest rate. Although, as always, with trading comes risk, and as such, if you do not have proper money management, you will end up losing a lot like with any other strategy and approach to trading.
