The Forex Carry Trade: A Primer

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Carry trading for regular income
Carry trading for regular income © forexop

There are several things that make carry trading interesting:

  • It produces real cash flows
  • It’s less time consuming than day trading
  • It can be lower risk than other strategies

Yet this important strategy is almost always overlooked by new traders who tend to focus on elusive “quick profits”.

Interest rates are one of the biggest drivers behind currency movements. And one of the main reasons for this is the carry trade. Put simply, carry trading is a strategy for profiting from the difference in interest rates between two currencies. That means “cheap money” is borrowed, converted and lent out at a higher rate of return.

How Currency “Carry Trading” Works

To properly understand the carry trade, we first need to look at what’s actually going on when a trade is executed in the spot forex market.

The spot market simply means for immediate delivery as opposed to delivery on a future date. When you enter into a trade, you in effect buy one currency and sell another for a given contract size, at the current exchange rate.

However, as most forex trading is speculative and done with borrowed money, it’s more appropriate to think of one currency being borrowed, and the other lent.

Just like when you go to a high street bank, when you borrow or lend money, interest payments are due. It’s no different in forex.

The basic aim of the carry trade is to borrow a currency with a low interest, and lend a currency with a higher interest. This results in a positive interest rate flow. Any due interest is paid to the trader – for as long as the position remains open.

This strategy can be very rewarding because interest is paid on the full amount of the contract. Since most forex traders use leverage, the carry trade can offer a substantial income yield. Though, this isn’t without risks (see below).

How To Choose A Currency Pair

In the last decade or so, the low interest currencies favored by carry traders have been the Swiss Franc (CHF) and Japanese Yen (JPY). Popular higher yielding currencies are the Australian Dollar (AUD) and New Zealand Dollar (NZD).

Let’s assume for this example that the base interest rate of the Australian Dollar is 2.5%. While the base rate of Japanese Yen is 0.1%. This means there’s a gross interest rate difference of 2.4%.

Now take a look at the cash flows in two opposing trades in AUD/JPY after one full day.

Buy AUD/JPY AUD JPY Sell AUD/JPY AUD JPY
Contract size $100,000 -¥9,250,000 Contract size -$100,000 ¥9,250,000
Gross interest $6.85 -¥25.34 Gross interest -$6.85 ¥25.34
Net interest $6.04 -¥100.10 Net interest -$7.66 -¥49.42
Net interest (AUD) $6.04 -$1.08 Net interest (AUD) -$7.66 -$0.53
Net interest (pips) 0.559 -0.100 Net interest (pips) -0.708 -0.049

Table 1: Cash flows in long/short carry trade example.

When we buy AUD/JPY, what we are doing in effect is borrowing Yen, and lending Australian dollars. With one standard lot, and the current exchange rate, this means we borrow ¥9,250,000 at an interest rate of 0.1% and lend the exact equivalent which is AUD$100,000 at a rate of 2.5%.

The gross interest rate in Table 4‑1 is the rate before the swap spread is applied. Below I explain how this is calculated. Notice that after applying the spread, the net interest paid on the short side is much higher than that gained on the long side. While beforehand (gross) it was identical.

After holding the position overnight, we are “owed” $6.04 from the lent Australian Dollars. And we owe $1.08 from the borrowed Japanese Yen. This is once the interest rate spread (the fee) has been included.

So the long side would give us a net daily cash flow of $4.96.

When we sell AUD/JPY the reverse happens. We must pay interest on the AUD, and we receive interest on the JPY deposit. But, the small credit interest on the Yen deposit becomes negative once the spread is included.

This means we must pay $8.19 per day to hold the short AUD/JPY position.

It’s important to note, these amounts are fixed overnight. The rate on any day will depend on the prevailing interest rates and fees charged both by the broker and the dealing bank (see below).

AUD/JPY “Buy-and-Hold” Example

Table 2 below shows the profit/loss statement for a long-term buy and hold carry trade. The amounts shown are for a long AUD/JPY position of size one standard lot. The table shows what would happen if this trade were opened at the beginning of 2004, and held for ten years.

Year Net Interest Income Exchange P/L Total P/L
2005 4.70% $4,714 -$420 $4,294
2006 4.90% $9,567 $6,040 $15,607
2007 5.30% $14,842 $13,680 $28,522
2008 4.00% $18,845 $17,370 $36,215
2009 3.40% $22,271 -$17,100 $5,171
2010 3.10% $25,392 $3,020 $28,412
2011 4.20% $29,608 $2,345 $31,953
2012 3.80% $33,452 -$1,764 $31,688
2013 2.40% $35,831 $9,512 $45,343
2014 2.20% $38,013 $12,941 $50,954
Totals 3.80% $38,013 $12,941 $50,954

Table 2: Long term returns in a 10-year carry trade.

The trade results in a net income of $38,013 in interest payments. The exchange rate gain over this period is $12,941. In this case, the payment stream from the carry interest more than compensates for the drawdown of the trade. The biggest being after the 2008 Lehman Brothers collapse – see Figure 1.

Even with a conservative 10x leverage, which would easily cover the position, this gives a total return of 509% and an annualized return of nearly 19.8% over a ten year period.

Not a bad return at all when compared to other investments over the same time period.

Carry trade income
Figure 1: Carry trade P/L over 10 year period. © forexop

Carry Trade Strategies

The basic carry trade strategies are:

  • Buy and hold – one or more positions are held for the long term.
  • Tactical – short term trades are placed for positive carry income.
  • Hedged – exchange rate risk is reduced or eliminated altogether.

If you’re planning on using a carry trade strategy, the first step is to find the most profitable combination of broker vs. currency pair.

Charges vary enormously among brokers, and across different currencies. So it’s essential to check that your planned trade actually offers the best risk adjusted return.

Don’t assume that carry trading will be profitable in every case. It might look that way at first glance. With some brokers, the interest spreads are so wide that they can make carry trades unviable.

The table below shows the top carry trade opportunities at the present time (see full table).

Broker Pair Direction Net Yield % 1 Year Interest/Lot
NORDFX AUDUSD Long 4.43% $3285.00
NORDFX AUDCHF Long 4.38% $3251.04
FOREX NZDJPY Long 3.30% $2339.53
NORDFX AUDJPY Long 3.24% $2406.50
FOREX NZDCHF Long 3.19% $2261.88
Alpari NZDCHF Long 3.09% $2188.92
FOREX AUDCHF Long 3.07% $2275.73
FOREX AUDJPY Long 2.64% $1957.29
ETORO AUDCHF Long 2.56% $1898.00
DUKASCOPY NZDCHF Long 2.55% $1806.75
HOTFOREX GBPNZD Short 3.01% $3795.27
HOTFOREX EURNZD Short 2.97% $3157.44
LITEFOREX EURNZD Short 2.89% $3080.43
NORDFX EURAUD Short 2.81% $2993.53
FOREX GBPNZD Short 2.63% $3324.13
ETORO EURNZD Short 2.57% $2737.50
DUKASCOPY EURNZD Short 2.48% $2638.95
FOREX EURNZD Short 2.41% $2567.02
ETORO GBPNZD Short 2.20% $2774.00
FOREX EURAUD Short 2.17% $2313.18

Table 3: Most profitable carry trade opportunities.

When setting up a carry trade, interest yield isn’t the only aspect to consider. If you’re planning on using a buy and hold system, it’s sensible to look at a long-term view on the pair too.

Some “exotics” may offer very high carry rates. Yet these currencies are often highly volatile and depreciate over time due to rampant inflation and other factors.

The Risks

The interest payments can provide a steady income stream in a carry trading setup. But the trader still has an exchange rate risk. That is, the risk that the currency exchange rate will change and cause a substantial loss on the trade. For this reason many carry traders implement a hedging strategy to protect them against these losses.

Hedging can be done using the futures market – e.g the “cash and carry trade”, by using offsetting positions, or with options.

Of course, the rate can move in favor of the trade and that would increase the profit to the trader  when there is no hedge.

What Influences Carry Currencies?

Real interest rates (adjusted for inflation) are one of the main drivers behind currency movements.

For this reason, currency pairs with carry opportunities often trend strongly in the direction of the interest rate differential. Trending can take place over very long periods of time when the economic backdrop is good and the interest rate expectations are upwards.

The main risk however is that higher yielding currencies are prone to steep and sudden sell-offs when the economic outlook changes or at times of extreme risk aversion.

These sell-offs are known as carry trade liquidation. When you have severe and sudden risk-avoidance, they can quickly turn into full-blown routs. Panic trading sets in and traders all look to unwind their positions at the same time.

Also, keep in mind that movement in carry trade currencies tends to be driven by the same fundamental reasons. What this means is that brutal crashes often impact all carry currencies in lock-step. Because of this, diversification across several pairs doesn’t help in most instances.

Figure 2 shows the massive liquidation of carry trades shortly before the Lehman Brothers collapse. This is followed by successive interest rate cuts due to the economic recession.

Carry trade vs libor
Figure 2: AUD/JPY verses rate differential (overnight Libor rates). © forexop

Carry Trade Profitability: Swaps, Rollovers, Yields

Just like when you lend or borrow from a high street bank, there’s a fee to pay. This is called the interest rate margin or spread. The dealing bank(s) plus the broker all add their fees into the mix.

This is why it’s important to understand the costs of carry trading and check what you’re actually being charged.

Most brokers do publicize their interest rate spreads on their websites. These are usually listed under rollover/swap charges.

It’s always good practice though to calculate the spread yourself to make sure there aren’t any “hidden extras”. This way, you’ll know the exact yield you’ll achieve with the trade. This is what you should always do before committing to any big carry trade positions.

What Is Rollover?

In the spot forex market, the convention is that settlement takes place two business days after the trade is booked. This is known as the value date. At that point, both parties would exchanges their currencies under the terms of the foreign exchange contract.

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However as the majority of forex traders don’t want to take delivery of a currency, brokers typically deal on a “rolling spot” basis. This means any positions left open overnight are automatically rolled forward to the next value date. With “rolling spot”, delivery is postponed indefinitely.

The rollover time varies from broker to broker. Most use the end of the New York session (5.00pm EST, or 10pm GMT) as the cut-off point. Any trade that’s left open after this point is automatically rolled-forward to the next value date.

As the value date cannot occur over a weekend, this means positions left open Wednesday to Thursday must have their value date rolled forward over the weekend, to the following Monday.

This means two additional interest days are added –because interest still accrues over the weekend even though the market is closed.

What is a Swap?

At rollover the trade parties have to settle any interest payments due. This is done via a swap agreement between the counterparties. This forms part of the foreign exchange contract.

The dealing bank will typically use an overnight rate such as Libor plus a spread to fix the interest amounts that are due. Bigger and more creditworthy brokers can demand a better rate. The arranging broker and intermediaries may then add their own mark-up as well.

The difference between the long/short swap values is the rollover– or swap spread. This is your carry trading cost.

How to Calculate Your Net Interest Yield

To calculate the spread for any pair do the following. Using a demo account, open two long/short test trades in your chosen currency. Leave the trades open overnight. If you do this Wednesday-Thursday, this counts as 3 days. The next day, check the swap/rollover amount which should show the interest paid and received on each of the two trades.

Now add the two numbers together and divide by two. The amounts will usually be shown in your account currency. To find the spread as a percentage, just convert the swap values into the trade’s base currency and divide by your lot size.

In the example in Table 1 above, the 1-day swap values on the long/short side where $4.96 and -$8.19. These were the net interest payments (in AUD). This gives:

Long side: net interest = $4.96 x 365 / 100,000 = 1.81%

Short side: net interest = -$8.19 x 365 / 100,000 = -2.99%

Spread % = (1/2) x ($4.96-$8.19) x 365 / 100,000 = -0.59%

So our net yield on the long side would be 1.81%, while the net yield on the short side would be minus 2.99%. The total spread being charged is 0.59%.

I’ve used 365 days for simplicity above, but your broker may use a different day count convention, e.g. 360 days.

Average swap (rollover) fees by broker
Figure 3: Average rollover (swap) fees by broker. © forexop

Checking Swap Rates using MetaTrader

If you use MetaTrader, you can easily check the swap rates by right clicking in the “Market Watch” window. Select your chosen currency pair, and then click on properties. The long/short swap values are given there – usually in points.

You’ll need to convert this to the base currency using your account settings. You can then use the above calculation to find the spread % and your net yield.

Comparing Broker Rollover Fees

Traders often overlook rollover fees when comparing brokers. Yet for some trading styles these fees can add up to a significant amount over time – especially when the account uses high leverage.

If you’re a day trader and always close positions intraday, then you should be able to avoid rollover charges altogether. If you trade intraday, make sure you’re not using one of the brokers that charges interest continuously (second by second, or hour by hour).

If your trading strategy is equally long/short and you’re not “carry trading”, the interest rates will net out to zero over time. What’s left is the interest rate spread. So it’s important to check, and factor it into your overall trading costs.

For example, if your broker’s interest rate spread is 0.5% and your average overnight holding is 1 standard lot, this means over the course of one year, your rollover fees will be 0.5% x 100,000 = $500.

If you’re trading on high leverage, rollover can represent a significant fee in proportion to the account size.

Table 4 below shows the swap fees applied by some leading brokers. Oanda doesn’t apply overnight interest. Instead it’s calculated second by second as a position is held. On average, the fee is comparable with other brokers. But, this is bad news if you’re a day trader. With an overnight rollover system you wouldn’t pay any interest at all.

Broker Rollover Spread (pips) Spread % Yearly Fee/Lot
Hymarkets Overnight 0.03 0.09% $88.40
Dukascopy Overnight 0.11 0.33% $332.98
Exness Overnight 0.15 0.40% $396.47
Forex Overnight 0.14 0.45% $451.55
Alpari Overnight 0.15 0.49% $493.13
NordFX Overnight 0.25 0.76% $755.28
FXOpen Overnight 0.23 0.77% $767.52
AAAfx Overnight 0.25 0.83% $833.01
Thinkfx Overnight 0.26 0.86% $864.63
Oanda Continuous 0.32 0.89% $889.19
Fxdd Overnight 0.27 0.91% $914.69
As of: December 2016

Table 4: Comparison of average rollover fees in pips and percent.

Exceptions

Another thing to watch out for is that some brokers apply higher spreads for different account types. A higher tier of charges may be applied to those who’re trading on high leverage accounts –or using other potentially risky trading tactics. The higher fees are to offset the additional credit risk carried by the broker.

The different rollover treatments means there would potentially be arbitrage opportunities between brokers if the interest rates where to go high enough.

Finally

Carry trading can be a profitable long-term strategy when managed correctly. It can provide a steady income stream. And this can cushion the impact of exchange rate losses on the trade itself. Hedging systems can also be put in place to manage and mitigate the exchange rate risks.

The Excel sheets below are used for carry trading and will do the calculations for you. Just enter your currency details and swap values.

Carry trade calculator (Excel)
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Cash and carry calculator (Excel)
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There’s also a Metatrader tool if you’re using that platform.

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About the Author

Steve Connell has spent over 17 years working in the finance sector as a trader/market maker and strategist. Over that time he’s worked for several global banks and hedge funds. Steve has a unique insight into a range of financial markets from foreign exchange, commodities to options and futures.

4 Comments
  1. Actually “Buy-and-Hold” does not work at all if you consider the market risk and margin cost.
    The way I do carry trading work much effectively.
    1. Choose Strong-Correlative currency pairs, such as AUD and NZD
    2. Create psedo hedging currency basket, Buy AUD/JPY, Sell NZD/JPY, See AUD/NZD
    3. Find the broker where the currency basket can generate positive swap.
    I created more than 100 currency baskets and have program running background, calculating more 100,000 trading patterns to find brokers where this approach is available.
    Now it works pretty well.

    • Buy and hold is obviously a disaster if you buy at the wrong time and extremely good if you buy at the right time. That’s the nature of it. It’s fully exposed to the exchange rate risk. Holding a basket can hedge out some of the variance but then there are extra costs with holding more positions including offsetting interest.

      I’m surprised you can make anything on a trade such as long AUD/JPY & short NZD/JPY right now, but if it works great. Are these all with the same broker?

  2. As much as I like the concept of the carry trade, can you please explain to me what do you do when you open your position in the beginning of 2004 (you enter at roughly 82) and over the course of the year the price drops as low as 74. This represents 800 pips of adverse movement that you need to account for. How much of a buffer you keep in your account, since only this negative 800 pips could have wiped you out without several thousand dollars of free margin?

    • The answer is in having enough free margin. This is not a strategy you’d want to leverage up on too highly. Carry trading is just like anything else – the higher the yield you want to achieve, the higher the risk and the more speculative the outcome is going to be.

      For example if you only had enough margin for an 800 pip movement that means a target return of roughly 50%-58%, depending on the free balance and the exact carry interest over the year.

      For a mini account for example with :

      balance (free): $800
      expected carry income: $471
      gives an implied yield: 58% in one year

      With leverage up to 30% to 40% and higher then carry trading becomes no different to any other kind of speculative trading. Then your outcome is more determined by exchange rate volatility than it is by income. There are some ways to mitigate exchange rate risk but still the risk is always going to be bigger with higher leverage and less free margin to play with.

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