As you continue increasing your knowledge about forex trading and the market in general, more and more new concepts and ideas will pop up. This includes a growing range of trading technique and strategies. One such trading strategy which has been around for a very long time in the industry, is the carry trade. Here we will take a closer look at exactly what a carry is in forex, and provide all the information you need to decide if carry trading is a good strategy for you as you move forward on your trading journey.

The Basics of How a Carry Trade Works

In its most simple form, a carry trade in forex, is borrowing one currency, and using it to buy another. For example, you may borrow (sell) $100,000 Australian Dollars, and use those funds to purchase the same amount of JPY. Placing a carry trade is one of the most popular trading strategies in the entire sector, and used by many traders to benefit from the position of currencies around the world.

So, what is the benefit in borrowing one currency and using it to buy another? This comes from the difference in interest rates between the two currencies. Let’s look again at our example in more detail.

Presuming the interest rate on the Australian Dollar was 4%, and the interest rate on the JPY was 0.1%, a carry trade would be where you buy the AUD/JPY market, as here, what you are effectively doing is selling (borrowing) Japanese Yen, to purchase Australian Dollars. In the most simple of ways, you will now have placed a carry trade. Here you will earn 4% interest on the Australian Dollars you are holding, while paying 0.1% interest on the Japanese Yen you have borrowed. This should leave you in a profitable position if the rate does not change, and is known as a positive carry trade at +3.9%.

Why is Carry Trading in Forex So Popular?

From an outside perspective, even looking at our hypothetical example where there is quite a gap between the interest rates, you may wonder why placing carry trades is so popular when the potential profit may seem quite small. There are two main elements at play in the forex market though which make this a very attractive type of trading strategy.

Currency Pairs: The fact that currencies are traded in pairs make a carry trade very accessible, and convenient for all traders. The difference in interest rates has never been so easy to take advantage of as it is in forex trading, where you can directly trade low and high interest currencies in pairs.

Leverage: The availability of extensive leverage in forex makes it the ideal place to carry trade. Many forex brokers can make leverage of up to 500:1 available on certain currency pairs. This basically means that even a relatively small deposit of $1,000 can open up huge buying power of $100,000 at 100:1 leverage, or more. Dealing with such large numbers, even low percentage profits are very meaningful.

Popular Forex Pairs to Carry Trade

Given the fundamentals of how a carry trade works, borrowing a low interest currency, to buy a high interest currency, then this is precisely what traders are on the lookout for in the forex market when it comes to placing a carry trade. There are a couple of currencies in particular that are most popular in this regard.

As a selling currency, the Japanese Yen is always a very popular choice. This is thanks to the historically very low cost of borrowing in Japan. The country has not had an interest rate of above 0.5% in more than 20-years. Another popular choice as a selling currency may be the Swiss Franc (CHF).

On the buying side, popular choices include both the Australian, and New Zealand Dollar as countries which typically hold slightly higher interest rates, yet are recognized as quite stable currencies.

Benefits of a Carry Trade

A carry trade in forex can be an excellent long-term investment strategy. You will have the potential to benefit from a carry trade even if the rates do not change at all thanks to the difference in interest rates. This makes it perfect for an investor who intends to hold the position for a long time.

Added to that, if the rate does change in your favor, then you can potentially have a sizable profit when added to the interest rate difference, and factoring in the leverage used. The fact that many brokers nowadays also cater for trading with very competitive fees and low spreads also plays to your advantage if placing a carry trade, and is something that many look out for.

Risks Involved in a Carry Trade

With every form of trading, there is always a certain element of risk. With a carry trade, though it is seen as a low-risk strategy, there are still a couple of things to be mindful of.

The market can still move against you. A change in the market can certainly negate any benefits you have gained from the positive interest rate difference. Particularly if you decide to trade in minor, or exotic currency pairs which are less common, you should note that these markets can be highly volatile, and subject to change in a very swift fashion. Some examples include trading with the MXN (Mexican Peso), or NGN (Nigerian Naira). Both may appear attractive for a carry trade, but can be subject to intense volatility. This risk can be amplified even further if you are trading with a lot of leverage.

You should also remember that, just because there may be a positive rate difference at the moment, the monetary policy in every country is subject to change at different times. The perfect example of this would be right now, in the midst of the coronavirus pandemic, many nations have moved to cut interest rates. This has the possibility to really change the dynamics of your carry trade.

As you gain experience trading the forex market, you will come across an increasing number of terms. One such term is a currency swap. These kind of transactions actually make up for a large amount of the volume traded on the markets, and they are commonly applied in a few situations when you are trading forex. Here we will explain in more detail exactly what currency swaps are, how they usually occur, and why they can be beneficial to certain types of traders in the sector.

The Basics of a Currency Swap

In the most simple of terms, a currency swap does exactly as the name implies. It is an exchange of currency between two parties of the equivalent amount of money in another currency. There is then a contract in place to repay this money at a specified date, and exchange rate in the future. In essence, this is a currency swap. A currency swap can bear some similarity to that of currency futures, though they differ in the sense that they are held until settlement, and considered to be a large part of forex trading, whereas currency futures are traded on other exchanges.

Currency Swap Example:

Party A, and Party B enter an agreement to swap €1,000,000 for $1,150,000. This fills the need for the counter currency for both parties, and creates an implied EUR/USD exchange rate of $1.15.

The transaction is then completed at a future defined date, using either the original exchange rate of $1.15, or another agreed upon exchange rate. Essentially, the two parties are loaning a particular foreign currency to each other. In some cases with currency swaps, this can include the payment of interest or principal amounts on loans, though this will depend on the details of the individual agreement.

Who Typically Engages in Currency Swaps?

Currency swaps used to be the preserve of those in countries where the foreign exchange rates were extremely volatile, or as where they could be used as a mechanism to overcome currency restrictions.

While this is still the case on a more limited basis, the use of currency swaps has increased around the world as investors and companies become increasingly multinational. Here are a couple of examples of where currency swaps are most often used to good impact in today’s forex market.

Companies Doing Business Abroad: Currency swaps may be particularly beneficial to businesses who have interests abroad and need to borrow in order to conduct this business. They may not necessarily benefit from favorable loan terms from banks outside their home country. Therefore, if they can borrow money in their home country at the best terms, and conduct a currency swap with a similar company in the country they are seeking to invest, then this trade could be of benefit to all involved.

Volatile Currencies: A currency swap may be beneficial, an almost essential in some cases, for institutional and retail investors in nations where the local currency is known to be volatile. This is one of the main purposes behind engaging in a currency swap, to guard against currency risk with more volatile currencies. By engaging in a currency swap, both parties can set the terms, and have a certainty around the cost of their trade.

As we can see with these examples, currency swaps are most often used by companies, and other types of institutional investors. This is certainly a more common situation than the use of currency swaps by retail investors, although in some situations, retail forex traders can be impacted.

Risks Involved in Currency Swaps

While currency swaps can be beneficial in the most part for the points noted above, just like any form of trading, they are not completely without risk. If you are engaging in a currency swap, here are a couple of the primary risks you can expect to encounter.

Interest Rate Fluctuation: One of the main purposes of engaging in a currency swap may be to take advantage of better interest rates in the currency that you are borrowing as part of the deal. These interest rates though are often left floating in contracts. Therefore, there is a chance that a change in the exchange rate could negate any of the cost-saving benefits you hoped to derive from the currency swap in the first instance.

Exchange Rates: With currency swaps, perhaps the most important element is the exchange rate. This is often pre-defined within the swap contract to be a set rate at the future time when the deal reaches maturity. Here again, there is a chance that the future rate is worse for one party than the original or current rate. In this case, there may be a slight loss on the swap.

Forex Trading Swap Fees

The term swap fee, or forex swap is something you will also encounter if you are an online forex trader. This can also be known as the overnight fee, or rollover fee, and may sometimes be confused with the currency swap.

This is a “fee”, though it can be either positive, or negative, that is applied to positions you hold open overnight when trading through your forex broker. This amount is constantly changing, and basically represents the difference in interest rates on the currency pair which you are holding. Therefore, holding a long position in certain currency pairs will see you credited with the positive interest difference, while short positions will see this fee deducted from your balance.

Final Thoughts

Although it is typically an area of more concern for more experienced, and institutional traders, the currency swap still plays a huge role in forex trading overall, and is a very useful trade to be aware of. This is particularly true if you are looking for one of the most secure ways to deal in a large amount of foreign currency and in a situation where you wish to add some degree of security or control to the trade over a long period of time.

• Negative Market Mood Pushes Traders Back to USD
• IMF Less Optimistic on Recovery Prospects
• US Markets Continue Torrid Week

It has been a turbulent start to the week on Wall Street. The forex market has also been impacted as traders move back to the perceived safety of the US Dollar. This movement has left particularly the EUR/USD under pressure. This has been compounded by an increase in COVID-19 cases and a revision of the global economic outlook from the IMF that has now become less favorable. The stock market too is pointing downward for a second consecutive day.

Euro Slips as Traders Move Back to USD

Forex brokers have noted a strong move away from the Euro and back to the safe haven green back in recent days. This has left the pair dipping below 1.12 again having regained a lot of ground on positivity in recent weeks. There are a number of stumbling blocks impeding the strength of the Euro, not least the increase in coronavirus cases around the US and the move by some states such has New York, to improve 14-day quarantine on domestic arrivals from certain states.

This has put the brakes on forex trading in the Euro market as the next market movements remain uncertain, and fears of a second wave persist. Eyes will be on today’s meeting of the European Central Bank for indications around how they plan to respond to the latest developments.

IMF Outlook on Recovery Revised

There was also not great news for traders from the IMF. They have moved to downgrade their previous forecast on the speed at which they expect the global economy to recover. In April, they had predicted a 3% fall in global GDP. This number has now been revised upwards to 4.9%, with the impact of the coronavirus on the economy being the source of these downward revisions.

The fund have also noted that their forecast for 2021 has been downgraded too. An initial growth rate of 5.8% has been cut to 5.4% with warnings that there is still a great deal of uncertainty around these numbers as the situation is constantly evolving. Looking at individual regions, the report suggests that the US economy is expected to shrink by as much as 8% this year, with the EU following suit at a contraction of more than 10%.

Stock Markets Set to Open Lower Again

After a large scale sell-off on Wednesday, US stock markets are braced to open lower still on Thursday. Both the Dow Jones, and S&P 500 are set to open with losses of more than 0.5% in pre-market trading.

These numbers will not be helped by the unexpected jump in US jobless claims which came in worse than expected this morning. Analysts had forecast the number to be 1.35 million, but the Department of Labor announced that 1.45 million Americans had filed for unemployment benefit in the past week. The second consecutive week that this number comes in higher than expected.