I just got back from an overseas trip which is why I didn’t update the post over the past few days.
I want to get back in the groove with an important post about a crucial concept that’s responsible for some of the shifts we’ve seen in the exotic pairs since the beginning of 2010: Currency Carry Trades.
What is a currency carry trade?
Currency trading is an investment strategy that involves taking out a loan in the currency of a country with low interest rates and buying with that loan a currency with a higher interest rate or some asset whose value is stated in that currency.
Why do people do it?
First of all, usually this isn’t done by individuals but by financial institutions, able to trade huge sums of money.
Second, they do it because it’s a way to make money with (what some people believe) very little risk.
How does currency carry trading work?
Let’s say that the interest rate in the US is 0.5% while the interest rate in… Brazil (for example) is 5%. The bank or financial institution takes out a loan on the USD and invests it in a bond or short term deposit in Brazilian currency.
The difference in currency is 4.5%. Let’s say you need to pay an extra 1% interest on the loan you took. You stand to earn a 3.5% profit. I’ve not taken into account any of the actual costs of the trades you make but that’s just for the sake of the example.
Now, take that profit and put a huge leverage behind it (as only big institutions can get) and you can turn that into a huge nominal profit.
Naturally, there is risk here. First, interest rates are liable to change. Second, the value of currencies can change very quickly (especially the exotic pairs).
You may be asking how does this concerns you as an individual trader. You can also do carry trades although it may not be worth the trouble because you may not be able to get a big enough leverage. However, all these huge carry trades that are taking place all around the world are changing the values of currencies and this can affect you tremendously.
What you need to do is be on the lookout for differences in currency rates and for any news items about currency pairs on which a lot of carry trades take place. This may provide a great opportunity for you to place some regular trades, riding on the waves of carry trades that the big institutions make.
Just one more Forex trading strategy for 2010.
