What is the carry trade? The carry trade is a name given to the strategy in which a simultaneously borrowing and selling of a currency with a relatively low interest rate takes place in which the purchase of a currency yielding a higher interest rate. What results is a way to capture the interest rate “carry” or rollover

You could then decide to invest that capital into an asset class with a higher yield (say 8%), earning yourself $70,000. As a result of the interest rate spread between the two, you would earn $70,000 with just a keystroke. At 10 to 1 leverage, you could earn $700,000 for the trade.

The dollar, because of low interest rates, is increasingly becoming a vehicle for the carry trade. Global bankers borrow the dollar while investing in higher dividend paying currencies pocketing the differences.

This cheap borrowing funnels itself into other assets commanding higher interest rates in turn can create other asset bubbles. If the greenback increases interest rates, the whole process becomes unglued.

Such maneuvers are reminiscent of the currency-depressing growth Japan had experienced and is still experiencing for the last 20 years with their near zero interest rates hyper deficit spending habits.

The Yen Carry Trade Example: For instance, if one were to buy the AUD/JPY currency pair, they would be selling Japanese Yet and buying Australian Dollars. In order to sell something you need to own it first. So if you are going to sell the Japanese Yen you have to borrow it first. Because of the their low interest rate, the Japanese Yen currently charges percent (0.50%) interest on that money.

There is risk. The trader wants to view the health of the economy for the currency pair to ensure the market will move to his/her favor. If one is in a dollar carry trade and interest rates in the dollar climb, the proposition falls apart.

With the US central bank flooding the world with dollars, short term interest rates are extremely low. This enables investors world-wide to borrow dollars at next to nothing interest rates and invest them elsewhere at higher rates. The dollar carry trade strategy in one of the reasons the dollar has continued to fall in value. If everyone heads for the exits to cover their shorts, a world financial panic could result.

The carry trade strategy entails one to borrow a currency at low interest rate and invest in a currency with a higher rate. Paying attention and on top of market and world events, one can avert large down draws. Get informed to the vicissitudes of economic fortune by a subscription Investors Business Daily.

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Filed under: Currency Trading

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