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Carry Trades: Earning Interest Mechanics

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The carry trade strategy’s one cornerstone is the capacity to earn interest. The income is accrued every single day for long carry trades with three times rollover which they provide on Wednesday to account for Saturday and Sunday rolls.

Approximately, they calculate the daily interest in the following way:

Daily Interest = IR long currency – IR short currency / 365 Days x NV

  • IR – Interest Rate
  • NV = Notional Value

Also, keep in mind that this amount can only be earned by traders who are long AUD/JPY. But for traders who are fading the carry, or shorting AUD/JPY, the interest is paid every day.

Why is Carry Trade Important?

Around January 2000 and May 2007, the Australian dollar/Japanese yen currency (AUD/JPY) offered an average annual interest of 5.14%. For a lot of people, this return is a pittance. However, in the market where leverage is as much as 200:1, even the use of five- to 10-times leverage can turn that return remarkably extravagant.

 

Also, investors can earn this return even if the currency pair did not move a penny. But with so many people addicted to the carry trades, the currency nearly never stays stationary. For instance, between February and April of 2010, the AUD/USD exchange rate gained almost 10%. Then, between January 2001 and December 2007, the value of the AUD/USD rose by about 70%.

Low Volatility, More Carry trades

Moreover, carry trades work well in low volatility environments. Here, traders are more willing to take on risk. Carry traders are always looking for the yield – all capital appreciation is just a bonus. Thus, a lot of carry traders, especially the big hedge funds with many money at stake, are absolutely happy if the currency will not move one penny. And this is because they will still earn the leveraged yield.

If the currency continues not to fall, carry traders will practically get paid while waiting. Aside from that, traders and investors are more comfortable with taking on risk in low volatility environments.

The Most Effective Way

In carry trades, at any given time, one central bank might be holding interest rates steady while another might be increasing or decreasing them. And with a basket the involves the three highest and the three lowest yielding currencies, anyone currency pair only represents a part of the whole portfolio. As a result, even if there is carry trade liquidation in a currency pair, the losses are managed by owning a basket. In fact, this is the preferred way of trading carry for investment banks and hedge funds.

Using this strategy can be somehow tricky for individuals because trading a basket will naturally need greater capital. But still, it can be done with smaller sizes.

 

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