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Risks of the Carry Trade Explained

Discussion in 'Forex Discussions' started by painofhell, Sep 27, 2015.

  1. painofhell

    painofhell Content Contributor

    Jun 24, 2015
    Likes Received:
    Few things captures the fascination of new traders to the FX market like the Carry Trade. While the Carry Trade is not without risks, which will soon be explained, there is an upside that shouldn't go ignored that can help traders benefit from this market in ways not readily available in other markets. In short, understanding how the Carry Trade works can open up the same benefit to your portfolio that banks have by earning interest on their clients deposits.

    How Interest is Paid

    When we're looking at interest paid, we're discussing on open positions when you're buying the currency pair that pays more interest than the currency pair you're selling. For example, if you are selling 100k EURNZD (a complicated example but worth noting), you are in effect selling Euros and buying NZD and the interest is paid on the notional trade size and not just the margin placed to hold the trade open. This trade would have you earning interest on the NZD, the currency you are long while paying interest on the EUR that has a negative interest rate, thereby allowing you to earn every day interest is paid.

    Interest Paid Calendar available here.

    An Example of Positive & Negative Carry With Risks Explained

    Given the example of using leverage of 10:1, it is unlikely that a carry loss (based on interest rate differential of two economies) would wipe you off the market as the leverage is incremental and relatively small especially in today's depressed interest rate environment.

    So here is a hopefully clean example using two commonly traded currencies with a large interest rate differential that would help drive home the point:

    100k Sell Trade in AUDJPY

    Daily Negative Carry: ($6.00)*

    Required Margin for Trade: $3,000 on a 2% Margin Account

    *The reverse would pay $3.00 a day if you were long AUDJPY, however that number has been higher historically when the RBA had a higher reference rate than it currently does at 2.25%

    Usable Margin:$7,000 - This is the amount that would been exposed to the negative carry of ($6.00) per day As you can likely tell, without a loss on the position itself or if the market were to be flat but you held open a trade, it will take a long time to hit a margin call, where you're usable margin of $7,000 dips below zero.

    If the currency pair were to not move and we just look at the interest penalty, it would take 1167 days or 3.19 years before a margin call would be incurred wiping you off the market. 1167 *$6.00/day would eat up the required usable margin. As you may know, 10:1 leverage is a mild example as many traders can and often do use more leverage which incrementally reduce the amount of time where your usable margin could diminish.

    On the positive side, in a case where AUD/JPY was held over multiple years can present nice upside as long as the downside risks are managed. Given the current payment on a positive carry of $3.00 per day, the annual payment on a A$ 100,000 would be roughly 1,096 or 1.1% annually on the notional amount. Of course, most traders use leverage so the exemplary trader with $10,000 in their account with the same position would earn $1,096/yr on the $10,000 or 10.9% per annum even though it's paid against the notional trade size. As you can see, if this example is extrapolated over time, the results can add up but that requires leverage to be employed.

    Naturally, leverage provides a two edged sword in that leverage can magnify gains as well as losses. Therefore, a losing trade based on a loss of pips as well as the carry trade can bring you to an exit point quicker than many traders would be expect. However, lets take a look at just the carry trade component in which a currency pair stays in a range while the trade collects or pays interest.

    Rare but Extreme Risks That Shouldn't Be Ignored

    The unwind of the Carry happens rarely but when it does the moves are rather aggressive. 2008 was the last time we've had a clear unwind and they are recognizable when the low-yielding funding currencies are bought back and the high-yielding currencies that the Carry Trade seeks are sold. While the moves are rare, the existence of them should encourage all to keep trailing stops in place while engaging this strategy.

    Happy Trading

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