Carry Trades

Most traders are familiar with CFDs and the concept of paying interest on long positions and receiving interest on short positions. What many people don’t know is that there is also an interest component to trading in currencies.

In futures contracts traded on the Chicago Mercantile Exchange the interest component is factored into the price of the contract, so you won’t see the interest coming into or out of your account. In FX trading, interest is calculated daily on positions held overnight and adjusted daily on your trading statements.

We will focus on the FX market, in which you are trading the performance of one currency against another currency. For example, the code FXADUS in ProfitSource tells us that we are trading the Australian Dollar (AD) against the US Dollar (US) in the FX market.

If we are long on FXADUS, we receive interest on the Australian Dollar at the overnight cash rate and pay interest on the US Dollar at the overnight cash rate. If we are short on FXADUS, we pay interest on the Australian Dollar and receive interest on the US Dollar. Though there may be some variation depending on your broker, these rates will be very close to the Central Bank Rates listed below (current as of 29 January 2008).

To access any of these currency pairs in ProfitSource, simply type FX followed by the two digit codes for the currencies you wish to analyse. For example, type FXEUJY to analyse the Euro against the Japanese Yen. The price scale you see will indicate the value of one Euro buying “x” Japanese Yen.

Let’s go back to the first example, the Australian Dollar against the US Dollar (FXADUS). Let’s assume we were long on the Australian Dollar against the US Dollar with a $100,000 position, meaning each “point” would be worth $US10. We would receive interest on our position at 6.75%, and pay interest on the position at 3.5%, meaning we would receive net interest of approximately 3.25% (6.75-3.5) on our position.

If we held the position for one night, we would receive approximately $8.90 in interest. ($100,000 x 0.0325/365). This is almost equal to one point per day in our favour, just for being in the trade.

This type of trade is often referred to as a “carry trade”. In recent times, the US Dollar vs the Japanese Yen was popular with traders and investors due to the large interest rate differential (US at 5.5% vs. the Yen at 0.50%). Chart 1 below shows the “Dollar/Yen” carry trade in its glory days.

Chart 1

click chart for more detail

The US Dollar was trending steadily upwards, meaning traders with long positions were making good profits as well as receiving interest just for being in the trade. Unfortunately, all good things must come to an end. With a falling US Dollar and falling US interest rates, this trade is no longer as popular.

However, with the interest rate on the Japanese Yen still at a low 0.50%, we can always look to another currency with a higher interest rate – such as the Australian Dollar against the Yen (FXADJY) or the New Zealand Dollar against the Yen (FXNZJY).

Bear in mind that a carry trade opportunity is not the first reason to take a long trade in either of these currencies. You won’t take a trade simply because it is a carry trade, since if it goes against you the interest payments won’t be enough to offset the trading losses. Chart 2 below shows a carry trade gone wrong on the New Zealand Dollar against the Japanese Yen.

Chart 2

click chart for more detail

Those who went long on the New Zealand Dollar against the Yen at the top were receiving net interest payments around 8% on their position sizes, or around 2 points per day in interest payments, but lost 2300 points in 24 days as the currency collapsed.

As long as you manage your risk and are patient, there is nothing wrong with only taking currency trades that pay interest. With trading, it’s important to have as many factors in your favour as possible. As your positions get larger over time, the interest received can be quite a nice addition to your yearly income.

Be Prepared!

Mathew Barnes