Carry Trade on the Forex Market
Carry is the most popular trading in the forex market, which is practiced by large hedge fund managers and retail speculators. Carry trade rests on the fact that every currency in the world has an interest rate attached to it. These short-term interest rates are set by the central banks of these countries: the Federal Reserve in the US, the Bank of Japan in Japan and the Bank of England in the United Kingdom.
The idea behind the carry trade is easy. Traders make purchases in currencies with high interest rates using currencies with low interest rates. For example, in 2005, one of the best pairs was the cross NZD / JPY currency. New Zealand’s economy, driven by China’s huge demand for commodities and a booming housing market, kept interest rates up to 7.25% and stayed at that rate. While Japanese interest rates remain at 0%. A trader with a carry trade strategy to buy NZD / JPY can generate 725 basis points in yield only. On a 1:10 leverage basis, the carry trade in NZD / JPY can result in an annual return of up to 72.5% of the interest rate differential, without the contribution of a capital increase. Now you can understand why carry trades are so popular!
But before you hastily decide and buy a currency pair with high yields, note that when carry trades are liquidated, the decline can be rapid and severe (harm). This process is known as carry trade liquidation and occurs when the majority of speculators decide that carry trades may not have potential future. With every trader looking to get out of his position at once, no offers and gains from interest rate differentials are not enough to offset capital losses.
Anticipation is the key to success: the best time to place in the carry is at the beginning of the interest rate tightening cycle, enabling traders to enter the market on the move as the interest rate differential increases.
Yes, Carry Trade is usually done by professional traders and in order to get big profits then it takes a large capital too.