Ok, the carry trade. What’s that? To be short, it’s an FX trading system used by some of the biggest and meanest hedge fund managers in the world. Since the 1980’s, they have made billions from this remarkably profitable trade in stable FX markets.

But in the last couple of years, the FX market has become very volatile. Hedge funds aren’t making their easy buck on the carry trade anymore. Like me, I know that you won’t be losing any sleep over their recent troubles. But I’m interested in making money from the carry trade so, in this blog, I’m going to show you how minnows like us can get in on the act.

If needed, this blog gives a good introduction to the FX market.

Example Of The Carry Trade
I’d love to get straight down to the making money part, but first I must give a bit some background information to what the carry trade is all about. Bear with me.

Simply, a carry trade is nothing more than borrowing at a lower interest rate and lending the money out at a higher interest rate. To execute it you need to find two countries, one with high interest rates and the other with low rates e.g. Australia with 7% and Japan with 0.5%. Then go long on the high interest rate currency and short the low interest rate one. In this example this means you would simply buy (take a long position) in AUD/JPY. And that’s it. This results in an annual 6.5% interest rate differential.

6.5% return for a year isn’t brilliant. But, like spread betting, the carry trade is done with leverage. Let’s say a hedge fund manages to get leverage of 100 times. The return is then 650% per annum. For a $100 million position, that’s $650 million over a year. As long as the AUD/JPY exchange rate stayed relatively stable (which FX exchange rates used to do), the fund would make lots of easy peasy money.

The Carry Trade Currencies
For a long time the currencies to go short on were the Japanese Yen (JPY) and the Swiss Franc (CHF). The currencies to go long on were the Aussie Dollar (AUD), New Zealand Dollar (NZD), South African Rand (ZAR) and Mexican Peso (MXN). However if a hedge fund manager didn’t fancy going for the big interest rate differential carry trade, he would use a ‘middle’ currency instead – US Dollar (USD), British Pound (GBP) and the Euro (EUR). The aim in that case being to reduce risk as the exchange rates with these ‘middle’ currencies is seen to be less volatile.

Current Interest Rates

These interest rates will change, but they are constantly updated here.

Traditionally, the most popular carry trades have been long USD/JPY, long AUD/USD, long GBP/CHF and long EUR/CHF. Like spread betting, these positions are mostly only held for a short amount of time, maybe only a day or so. Hedge funds pick up their overnight interest rate and then reassess the position. Following on from the example above, one day’s interest would make 1.78% or $1.78 million on a $100 million position.

What Are The Risks?
This all sounds far too easy. There must be some risks and indeed there are. Here are two main ones:

1. The possibility of a falling interest rate differential.
   For years, USD/JPY was a favourite of the carry traders. In September 07, the US interest rate was 5.25%. It’s now 2%. Thus, the interest rate differential has fallen from 4.75% to a mere 1.5% in less than a year. The Bank of England is likely to reduce their rate in the near future, among others.
2. Rising FX volatility.
   Volatile markets make it more likely that the currency that you are short on could rise. For example, the USD/JPY exchange rate has fallen 5% in 2008 so far.

Let’s do some quick math. The fall in USD/JPY exchange rate of 5% outweighs the 1.5% interest rate differential by 3.5%. Given a $100 million position and 100 times leverage, the hedge fund is staring at a $350 million loss per annum!

Risk Number 1 isn’t too big of an issue. Although there have been some notable exceptions, interest rate changes are usually well-flagged by Central Banks. But Risk Number 2 is scaring the carry traders big time. It’s becoming less clear where the different currency pairs are going. Small exchange rate moves can be covered by the interest rate differential over time. But if the currency you are short on goes on a big run (e.g. JPY), the fund could be hit with huge losses. A long AUD/JPY would have to be closed out at a much lower level. This is what is becoming more and more frequent. Risk departments are putting their foot down on such uncertain trades.

So we’re down to the bones of what the carry trade is all about these days. It’s an FX strategy for when the market is in a risk taking mood. The trade is put on when the market is relatively bullish and volatility is low. AUD, NZD and ZAR gain in this instance. But if there’s uncertainty, risk and volatility in the market, carry trades are pulled back off. JPY and CHF then benefit.

Where Do Us Spread Bettors Come In?
“But I don’t have a $100 katrillion hedge fund to take advantage of all this.” That doesn’t matter, as we can still make money from the carry trade with a small spread betting account. It all boils down to making the correct call on the extent of trader risk appetite and market sentiment.

When the carry trades are being put on, the high interest currency gains against the low interest currency e.g. AUD will rise compared to the JPY. It’s up to us small guys to spot this and get in on the upward move of AUD/JPY. We might not have millions to deposit but if we are aware of what’s happening and get the timing right, we can ride these currency swings and make a nice profit.

What’s The Carry Trade Situation Like Now?

Let’s have a look at the recent action on AUD/JPY, the riskiest mainstream carry trade in FX land. Notice the recent downward trend in the past month as the banking crisis deepened. This shows a net reduction in carry trades as traders look to move to safer assets. This has provided strength for the Japanese Yen, so AUD/JPY fell. The pair fell 4.84% on Monday, the 15th September. This was the day that Lehman Brothers announced bankruptcy. Traders ran scared as nobody knew what would happen next and how many more banks would fail. With so much uncertainty traders wanted to minimise their risks.

However a lot of those fears were alleviated on the 19th as US Congress announced a bail out plan, providing stability and confidence to the market. AUD/JPY soared 5.64% as the carry trades were put back on. And why not, the US government will just bail out your riskiest investments anyway!

AUD/JPY is the most extreme example of the carry trade, but the other high/low interest rate pairs paint similar pictures. After Lehman’s bankruptcy, USD/JPY was down 3.02% that Monday, GBP/CHF down 1.59% and EUR/CHF down 1.23%. The leveraged carry trades were taken off across the board.

How Am I Trading This?
In the short term, I’m looking at it day to day. The news flow has caused wildly volatile markets. It’s risky to stay in a position overnight as you don’t know what big news story you might wake up to. But my tendency is to lean towards a short position on the carry trade currencies… in other words I’m looking to trade of the back of the big players closing out the carry trades.

To spell it out, when I get the time, I watch the news closely. If I feel there is more negative sentiment in the air I’m looking for opportunities to go short on USD/JPY and GBP/CHF. However when the sentiment changes, I’m passing up any chances to go long USD/JPY and AUD/JPY. That’s because, for the moment, I feel that every bit of confidence the market gains get crushed with a negative swing the next day.

In the medium term, I think that the carry trades will continue to unwind and USD/JPY will retest the lows it set back in March of this year. It could take a volatile while to get there though so I’m setting a wide stop loss. But overall, I think that there will be less carry trade action in the next few months. Financials and hedge funds are trying to de-leverage in an attempt to shore up their shaky balance sheets. Cutting back on carry trades is certainly an option they’ll be looking at. This will provide strength for the weaker currencies like the Japanese Yen. If my feelings are to be proved correct, looking for short GBP/CHF and short EUR/CHF trades should also do nicely for the rest of the year.

The Future Of The Carry Trade
It’s no secret that the Bank of Japan has disliked its Yen being the funding currency of the carry trade for all these years. They have claimed that this has kept their currency artificially low and has damaged their economy. But, despite their best efforts, they haven’t been able to stop the global market.

My opinion is that the carry trade will always exist as long as a decent interest rate differential exists. No amount of global and exchange rate risks will stop some crazy traders looking for a quick buck. But the global world is changing with the banking crisis we are now going through. Risk departments and regulation may clamp down on these very risky trades. The financial world is de-leveraging. It looks like the carry trade may have a much smaller role in the future.

“Hooray”, cheer the Japanese and its Yen.