Leveraged Carry Trade Strategy
You might have heard a lot about carry traders in the financial media. But what is carry trading? Carry trading is a long term strategy that involves selling a low yield currency and buying a high yield currency. The difference between the two yields is the profit that the carry traders make. Let's make it clear with an example. Suppose, Japanese Yen (JPY) deposits offer only 0.35% interest rate while the New Zealand Dollar (NZD) deposits offers an interest rate of 4.35%.
Carry trade is one of the fundamental trading strategies that uses one of the basic economic principles that money constantly keeps on flowing from a low interest market to a high interest market. Markets that offer the highest interest rate attract the most capital. Countries are no different. Countries offering a better interest rate attract more capital as compared to countries offering low interest rate.
Now, this is how carry trading works. Suppose a Japanese saver finds out that NZD deposits offer an interest rate of 4.35% whereas at the moment she is only getting 0.35% interest on her JPY deposit. She sells JPY and buys NZD to profit from the high interest rate offered on NZD deposits.
Carry trading strategy works when the investors have low risk aversion and they are willing to invest in a high yield currency. When millions of savers in Japan sell JPY to buy NZD, NZD will appreciate and JPY will depreciate.
This is the scenario when the risk aversion amongst the investors are low and they are willing to risk investing on a high interest rate currency. But when risk aversion amongst the investors increases due to some financial crisis and they tend to seek refuge in safe haven currencies, carry trading strategy fails as capital starts to flow from high interest rate currencies to low interest rate currencies.
Now, if you use leverage in carry trading, the profit multiplies. Leveraged carry trade is a popular trading strategy used by the hedge funds. Suppose, you use a leverage of 5:1, the interest rate differential of 4% becomes 20% giving you substantial profits. Increase leverage to 10:1, your profit will soar to 40%.
But, you need to remember that using leverage is a risky business and it is a double edged sword that cuts both ways. When things work well, your profits multiplies by using leverage. But when things don't work well and market takes a turn, your losses also multiply. So before, using leverage you should think twice!
Article Source: FxTradingStock.com
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by: Ahmad Hassam
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Word Count: 420
Date: Mon, 17 Jan 2011
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