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The Carry Trade

By:   Eric Stout
  • 05-05-2008
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There is a trading strategy in the forex market with which you can make money 24 hours a day, seven days a week. You can make money with this strategy even when the currency pair doesn't move.

The strategy is immensely popular among smart money managers, including multi-billion dollar investment banks, global hedge fund managers, and even individual forex traders.

The strategy is the carry trade.

The carry trade involves simultaneously buying a currency with a high interest rate and selling a currency with a relatively lower interest rate. You make money on the difference between these interest rates, which is known as the interest rate differential.

The currency with the higher interest rate is known as the target currency. The currency with the lower interest rate is known as the funding currency.

It works like this:
Let's say you go to a bank and borrow some money. You take out a loan for $10,000 U.S. dollars at an interest rate of 4%.

After finalizing your loan, you walk out from the bank and notice another bank across the street is paying an interest rate of 6% on deposits. You conclude that it's your lucky day and decide to deposit the money you just borrowed.

By doing so, you can sit back and collect the difference between interest rates, or 2% per year. This amounts to $200 of free and easy money.

The 2%, or $200 per year, is not a whole lot in the real world. But in the world of forex, this interest rate differential is huge. We get leverage and daily interest rate payments in the forex market, which makes the carry trade one of the most lucrative trading strategies around. The carry trade is a pretty simple strategy in theory. You simply want to match a higher yielding currency against a lower yielding currency.

It's best to buy the currency of a growing economy, in which interest rates are rising. Classic target currency examples include the GBP, AUD, and NZD.

Conversely, it's best to sell the currency of a slowing economy, in which interest rates are falling. The ideal set of economic conditions matches one of the aforementioned target currencies against the typical funding currencies such as the CHF or JPY. The carry trade flourishes during periods of economic and political stability. But these conditions don't always exist.

A lot of traders, including commercial banks and billion dollar hedge funds, run into trouble with the carry trade when they over-leverage or concentrate too much capital in a single position. But I can teach you how to avoid the risk of ruin. I can show you how to stay diversified, use the right amount of leverage, and when to get in and out of a carry trade.

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