In our last lesson we looked a little deeper into one of the more popular strategies traders use in the forex market, the carry trade. In today's lesson we are going to continue our discussion on the carry trade with a look at some of the factors outside of current interest rate differences that must be considered to have a full understanding of all the factors included in a carry trade strategy.
As we have learned in our first two lessons on the carry trade, it is the size of the difference between interest rates in the countries whose currencies we are trading that ultimately determines how much we either pay or receive for holding a position past 5pm New York Time. With this in mind it is only logical that if the difference in interest rates between two countries changes, then so will the rollover amount that is either paid or collected when trading those country's currencies.
As a quick example lets take another look at the NZD/USD. As of this lesson if we were to buy the NZD/USD currency pair then we would earn $10 for each contract we held past 5pm NY time. As we have learned in our first two lessons the reason why we would earn $10 is because we are long the NZD where currently interest rates are at 8.25% and short the USD where interest rates are currently 2% as of this lesson. So with this in mind we are long the positive interest rate differential of 8.25%-2% which equals 6.25%.
Now lets say in our example that interest rates in the United States went up by 1% to 3%, while interest rates in New Zealand stayed the same. If this were to happen then our positive interest rate differential of 6.25% would drop to 5.25%. Very simply here, as the positive interest rate differential has decreased the amount of money that we earn for holding the position has decreased as well.
Conversely, if rates were to rise in New Zealand and stay the same in the United States then the interest rate differential would grow in our favor, and the amount we earn for holding a position past 5pm should grow as well. So you can see here that one of the first things that must be considered when thinking about a carry trade is what the current interest rates are, and what they are expected to be for the life of the trade.
A second thing which must be considered when thinking about a carry trade is the exchange rate fluctuation that may occur while a trader is in the position. Traders may consider a number of things here, the most popular of which are one of or a combination of:
1. Capital Flows: Most importantly here is interest rate expectations which as we discussed in our lesson on how interest rates move the forex market, when interest rates rise in a country, interest bearing assets generally become more attractive to investors, which will many times drive the value of a currency up all else being equal, and vice versa when interest rates fall.
Notice here that I say interest rate "expectations". As we have talked about extensively in module 8 of our free basics of trading course, markets anticipate fundamentals so in general once an interest rate increase or cut is announced, it has already been priced into the market.
2. Trade Flows: Most importantly here is affects on the current account.
We will be discussing how traders go about forcasting changes in capital and trade flows in the coming lessons. The third thing which traders focus on and which we have already covered in our basics of trading course is:
3. Technical Analysis: As carry trades are generally longer term trades many traders will look at the overall trend in the market and use technical analysis to try and determine when they think the trend is going to be in their favor if they open a carry trade.
The importance of developing a plan to trade the exchange rate fluctuation portion of the carry trade in addition to the simple holding of a position overnight to earn interest cannot be overstated. To help drive this point home lets have another look at the chart for the NZD/USD.
As you will notice from this chart, in a little over 3 months the NZD/USD has fallen over 500 pips. As we learned in module 2 of this course the value of a 1 pip move in the NZD/USD currency pair is $10 meaning that in US Dollar terms this is a $5000 loss had a trader entered a long position at the top of the market to try and take advantage of the positive carry. If you remember from our last lesson at the current rate of $10 per lot held past 5pm NY Time a trader would earn $3640 for holding a position for 1 year, which in this case would unfortunately not be enough to offset the $5000 loss that was taken in 3 months.
As a homework assignment for tonight I would like everyone to think about the following question:
What are some possible reasons that the currency pair has sold off so much, and could they have been predicted?
If you would like to post your thoughts in the comments section of this lesson on InformedTrades.com we would love to see them and I will personally reply to all comments.
That's our lesson for today and that wraps up our lessons on the basics of the carry trade. In tomorrow's lesson we are going to start a new series on the fundamentals of the forex market where we will delve into how traders go about forecasting interest rates for things like the carry trade so we hope to see you in that lesson.
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