BeForex

The Carry Trade: What lies behind it?

The currency exchange market has been one of the basic pillars of economic activity over the centuries, but it is only recently within reach of retail traders. The depth, and sophistication of the forex market, its wide reaching influence on the global economy, and its importance in the eyes of policy makers and major economic actors make it an ideal place to learn about economics and trading in general. Many beginning traders try to learn about this exciting new market by employing relatively low-risk strategies such as the carry trade where directional bets are made in anticipation that currencies that offer higher yield, or interest income will appreciate against others. But what really causes this situation? What is the driver behind market movements, and what is the rationale behind the carry trade? We’ll examine this subject briefly in this article.

Although traders often reduce the logic of the carry trade to a simple flow of money from lower yielding to higher yielding currencies, the fact is that the role of the interest rate itself is only a part of the cause behind the trends that create the carry trade. In many cases, the beneficiaries of the carry trade are nations that are less developed than the major powers of Europe or America. Since these nations have a lesser need for capital (they produce sophisticated goods such as computers and cars, and sell them to the developing world where population is increasing faster) the money that cannot find itself a profitable destination at home is channeled to nations such as Turkey, Ukraine, South Africa, Russia, and others, where there is a greater demand for capital, and higher potential for growth. As investors and major firms from Japan, Europe, and the U.S. move capital to poorer nations for profit and greater returns on investment, they naturally need to acquire the currencies of these poorer nations. This flow of capital leads to an oversupply of money at the local level, and causes central banks to raise interest rates. As the rates rise, people whose main aim is exploiting the interest rate differential (carry traders) also channel funds to these less developed countries, and establish the main trends of the carry trade.

As we see, the carry trade is essentially based on meaningful and strong fundamental dynamics. Unfortunately, however, as more and more people seek to profit from it, bubbles may arise, the bursting of which can be rapid, unpredictable, and very destructive for those on the wrong side. Especially currencies of nations with deficits suffer great losses at such times.

The carry trade is among the most popular and profitable forex strategies known to traders today. Although it is risky like any other kind of trading activity, at times of healthy economic growth it allows exceptionally smooth, and reliable gains over the long term with reasonable leverage. Ultimately, the carry trade may or may not be your style, but only the blind would choose to ignore a strategy which has influenced market events so powerfully over many years, and will continue to do so for the foreseeable future.