What is the Carry Trade?

Did you know there is a trading strategy that can make money if the price stayed exactly the same for long periods of time?

Well, there is and it’s one the most popular ways of making money by many of the biggest and baddest money manager mamajamas in the financial universe!

It’s called the “Carry Trade“.

What is a Carry Trade?

A carry trade involves borrowing or selling a financial instrument with a low interest rate, then using it to purchase a financial instrument with a higher interest rate.

While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased.

So your profit is the money you collect from the interest rate differential.

Carry Trade Example:

Let’s say you go to a bank and borrow $10,000.

Their lending fee is 1% of the $10,000 every year.

With that borrowed money, you turn around and purchase a $10,000 bond that pays 5% a year.

What’s your profit?

Anyone?

You got it! It’s 4% a year! The difference between interest rates!

By now you’re probably thinking, “That doesn’t sound as exciting or profitable as catching swings in the market.”

However, when you apply it to the spot forex market, with its higher leverage and daily interest payments, sitting back and watching your account grow daily can get pretty sexy.

To give you an idea, a 3% interest rate differential becomes 60% annual interest a year on an account that is 20 times leveraged!

Leveraged Carry Trade Example:

Let’s say you borrow $1,000,000 at an interest rate of 1%.

The bank won’t just lend a million bucks to anybody though. It requires cash collateral from you: $10,000.

You’ll get it back once you pay back the money.

Your loan is approved so fill up your backpack with cash.

Then you turn around, walk across the street to another bank and deposit the $1,000,000 in a savings account that pays 5% a year.

A year passes. What’s your profit?

You earned $50,000 in interest from the bond ($1,000,000 * .05).

You paid $10,000 in interest ($1,000,000 * .01).

So your net profit is $40,000.

With a measly $10,000, you earned $40,000! 

That’s a 400% return!

In this section, we will discuss how carry trades work, when they will work, and when they will NOT work.

We will also tackle risk aversion

WTH is that?!? Don’t worry, we’ll be talking more about it later.

Reprinted from Babypips, the copyright all reserved by the original author.