How to Make Money From Interest With the Carry Trade on FOREX
In the foreign currency exchange market, a FOREX carry trade is a strategy that exploits the different interest rates available for different foreign currencies. Traders purchase debt instruments in high-yielding currencies while simultaneously selling low-yielding ones. By using high leverage -- financing most of a currency trade with money borrowed from a broker -- traders can magnify the gains, and also the risk, associated with the carry trade. Because earning interest requires the passage of time, carry trades tend to span weeks or months. For this reason, you must carefully monitor them to detect fundamental market changes that negatively impact revenue.
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Instructions
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Find the current yields of different foreign currencies using your broker's trading software. Divide currencies into high-yield and low-yield groups. Select a high yield currency as your base and a low-yield one as your counter currency. For instance, the currency pair AUD/JPY is composed of the Australian dollar as the base currency -- the currency you are buying -- and the Japanese yen as the counter currency you are selling. The Australian dollar has historically had a much higher yield than the Japanese yen. Your net interest income will be what interest you receive on the Australian debt less what interest you pay out on the Japanese debt.
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Purchase one or more lots of your currency pair, preferably composed of currencies that are not particularly volatile, as you are seeking interest income, not trading gains.
Some traders purchase a basket of three or more currency pairs to diversify risk. A lot costs the equivalent of $100,000. You only put up a small percentage of the actual cost; this is the margin, or collateral, of the trade. Your broker provides the remaining cash necessary to finance the lots you buy. You can leverage FOREX currency pairs up to 100:1, although such a high level of margin buying is considered very risky. A more suitable leverage ratio for a long-term carry trade is 5:1.
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Enter a stop loss order for your currency pair. The stop loss closes out a trade if it loses more than the amount you specify. Because a carry trade is long-term, you will want to set your stop loss sufficiently below your purchase price -- on the order of 15 percent or more -- so you are not prematurely stopped out of your position.
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Monitor the price swings of your currency pair over time. If your investment begins to lose value because of unfavorable exchange rates or interest rate trends, consider closing out your trade and finding a more desirable alternative. Assuming a relatively stable environment, hold your position for as long it provides the net interest revenue you demand.
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Tips & Warnings
Plan in advance how to invest the interest income you receive. You want to reinvest it at a rate similar to the rate you are earning on the carry trade. If you reinvest your interest at a lower rate, the overall yield on your carry trade will drop, lowering your performance. One strategy is to buy certificates of deposit in a high-yield currency other than your base currency. This diversifies your interest rate risk to some extent.
Economic shocks often cause a flight to quality in trading markets. In the FOREX market, this means traders will buy U.S. dollars and dump other currencies. You should determine in advance how your currency pair will react to an economic shock and quickly close out your position if you predict an adverse affect.
