Inefficiency: The Carry Trade
Forex traders have multiple - it could almost be said infinite -
strategies to trade the forex market and to take advantage of market
The "carry trade" is a forex strategy that plays on the fact that
different nations, being able to attract a higher flux of capital, and
having different level of economical and industrial development, offer
different interest rates, some higher than others. As we saw in
Currency Trading and The Forex Capital Markets, this fact,
representing market inefficiency, is in turn a trading advantage that
can be exploited by forex traders.
The carry trade involve buying a currency of a Country that has a high
interest rate and selling a currency of another Country that, on the
other hand, has a lower interest rate. Forex traders are thus able to
profit in two ways: -- Earn the difference in the spread (the
difference between the two interest rates) of the two currencies, and
-- Earn form capital appreciation
Usually the spread in interest rates is not very large and can be
expected to be in the order of 3% to 4%; however, it should be
regarded from the broader perspective of the leverage offered by forex
and by the lower risk that, at least compared to other forex trading
strategies, this system entails. In fact, when factoring in 20:1 or
even higher leverage ratios (some forex traders can trade these
currency exchange rate inefficiencies with up to 200:1 leverage).
As we noted below, the carry trade can profit from two sources;
however, capital appreciation can work against the forex trader; in
fact, if capital depreciate, the forex trader will be losing money on
this part of the trade, and at the end of the day it is the sum of the
two streams (difference in interest rate spread and capital
appreciation/depreciation) that will give the verdict as to whether
the overall forex trade was successful or not. Forex traders
performing this type of strategy are obviously looking to earn both
yield from the interest rates spread and the appreciation of the
currency pairs: it is thus crucial to determine in which Countries
(that is, which markets) carry trades will Produce the higher returns
with a level of risk in line with the returns expected by the currency
trader. This is indeed very difficult to answer; certainly, the forex
market is driven by fundamental for a large extent, but it is the
psychology of people and their swings in mood that most drives the
forex markets. Investing in a Country that pays high interest rates is
riskier that investing in a country that pays lower interest rates
because a developing country, thirsty for capitals and money will want
to attract the resources it needs by encouraging investors and forex
traders with higher returns for their money. However, such a country
has intrinsically a higher risk profile and ultimately it is the forex
trader that must be willing to take its chances after carefully
evaluating the multiple factors coming into the picture.
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