Understanding Currency Carry Trading

Carry
trading involves borrowing a low yielding currency and buying a high yielding
one in order to profit from the interest rate differential. You may have
noticed when trading CFDs on forex that you get charged overnight swap fees at
the rollover time (which is at the end of the trading day). Those swap fees are
calculated on the interest rates involving the two currencies in the pair you
are trading plus other commissions and costs of the broker.

For
example, if you short USD/MXN you are credited interest and therefore you
profit not only from the trade going in your favour but also from pocketing the
interest from the broker every day. This is an example of a positive carry
trade. On the other hand, if you were to go long USD/MXN and hold it more than
one day, then you would be debited an interest from the broker, and this would
be called a negative carry trade.

Back
in 2020 with all the stimulus from governments and central banks that made the
market expect an economic recovery and a following growth, the carry trades
involving EM (emerging markets) currencies were absolutely the best ones in the
FX space. Below you can see a daily chart of USD/MXN that spiked hard during
February/March 2020 and then started a year long decline.

One
of the most famous funding currencies has been the JPY and the carry trades
involving it amounted to an estimated 1 trillion dollars back in 2007 before
getting unwound as the Global Financial Crisis (GFC) hit.

Carry
trades are generally taken when there’s a risk propensity in the markets. In
fact, when there’s a risk on sentiment you will generally see the funding
currencies involving carry trades perform badly as they are sold against high
yielding currencies. On the other hand, if there’s risk off sentiment you will
witness what is called “unwind” and the funding currencies are bought back
gaining in value.

This
article was written by Giuseppe Dellamotta.