Forex] The Carry Trade

It is important to know central banking and interest rate policies when forex trading. Interest rates affect the flow of money globally as money will always find its way to highest interest rate economies. In this blog I’ll offer you a strategy that a hedge fund managers use when trading the forex market.

I’m assuming you don’t have £500 million to invest? So I’ll explain how a fund manager borrows cheap money to trade with and then offer you a simple trading strategy you can use to profit. a hedge fund manager will take a loan from the BOJ (Bank of Japan) it will charge approx 0.5% (that’s cheap right?) They will then use this cheap money to trade with. They’ll still have to repay the loan plus interest, however like me I’m sure you’ll agree it’s a sweet deal.

I’ll offer you an example; if a hedge fund has 500 Million GBP of client money. They could borrow £15′000′000′000 of JPY (Japanese Yen) from the BOJ, I’m using quite low leverage levels. The money costs the hedge fund 0.5% in interest. The fund manager now converts the Yen into AUD (Australian Dollar) and invests it in the Reserve Bank of Australia. The investment earns 4.25% annually. The interest rate difference between interest earned and the interest paid is 3.57%.

Interest rate received from Reserve Bank of Australia 4.25%

Interest rate paid to Bank of Japan 0.5%

Hedge Fund makes a profit of 3.75%

The trade is based on interest rate differentials, this is the carry trade hedge funds attempt to stay in the trade for as long as possible because they get their interest rate payment if the market goes up or down. What they are doing is converting JPY into AUD, to do this they are selling JPY and buying AUD. When this trade is popular there is huge demand for AUD. What happens when a product is in demand? It rises invalue and so does the value of AUD when it’s in demand and what happens when something is being sold heavily? It declines in value, as JPY will when the carry trade is in full effect and it’s being sold to finance the purchase of AUD.

So how do we take advantage of this as forex traders? We follow the professional money and buy AUD and sell JPY. Of course we still use forex technical analysis and technical indicators to confirm our bias and define our entry level, as professional traders we aren’t just going to buy at “market price” we are going to wait until AUDJPY is at a price level that offers us an edge.