Forex Interest Rate Trading Strategy

What Is Carry Trade Trading?

Carry trade trading is best described as a trading tactic where you use a high-yielding currency to fund trade with a low-yielding currency. The aim is to take advantage of the interest rate differential.

If the currency with the low yield (also called funding currency) has a significant difference from the currency with the high-interest rate then profits can be made with the carry trade. When a carry trade is combined with leverage, then these profits can be significant.

Interest payments occur every business day at 5:00 PM EST which is when the open position rollover. The 5:00 PM EST is considered to be the standard closing time in the 24/5 forex market.

In the forex market, we can recognise two types of carry trades:

1. Positive carry trade occurs when you buy a currency with a higher interest rate and simultaneously sell a currency with a lower interest rate
2. Negative carry trade occurs when you buy a currency with a lower interest rate and simultaneously sell a currency with a higher interest rate

What Is An Interest Rate?

Interest rate is the payment charged by a lender to a borrower for the use of an asset or other financial instruments. Usually, the amount charged by the lender is expressed as a percentage of the principal. When talking about interest rates, the compounding effects are often taken into account. This provides a more accurate interest rate known as the effective interest rate. This interest rate is expressed on an annual basis.

The table below reflects the current interest rates in the world’s major economies, as of Dec 2021.

Note* High-interest rate currencies are USD and CAD, and on the other side of the monetary policy spectrum, we have low-interest-rate currencies like the Japanese Yen (JPY) and Swiss Franc (CHF).

For example, if you want to borrow US dollars (USD), you’ll have to pay an annual percentage rate of 0.25%. On the other hand, if you want to borrow British Pounds (GBP), the interest payment is 0.10%

The national central bank of a country determines the interest rates that will apply. All countries have a central authority body, called the central bank. It is responsible for overseeing the monetary policy of a nation and managing the stability of its financial system. The monetary policy of the central bank will determine what the interest rates should be as it is a primary tool to manage the money supply in the market.

Other economic indicators used by central banks around the world are inflation, unemployment rate, GDP, retail sales, housing data, etc.

A list of the most influential central banks around the world is as follows:

1. U.S. Federal Reserve System (Fed)
2. European Central Bank (ECB)
3. Bank of England (BOE)
4. Bank of Japan (BOJ)
5. Swiss National Bank (SNB)
6. Bank of Canada (BOC)
7. Reserve Bank of Australia (RBA)
8. People’s Bank of China
9. Reserve Bank of New Zealand (RBNZ)

What Is An Interest Rate Differential?

The interest rate differential (IRD) is the difference in interest rate between two currencies. If the interest rate of currency A is 4.5% and the interest rate of currency B is 0.5%, the interest rate differential between currency A and currency B is 4.0%.

Note* High-yielding currencies tend to attract more capital and are more likely to rise over the long term.

There are different ways to calculate the interest rate differentials:

1. The standard method is where we subtract one currency’s interest rate from another currency’s interest rate and we get the difference.
2. Overnight swap rates.
3. Interest rates are derived from interbank rates.
4. Interest rates are calculated directly from the currency market. This is the difference between the spot currency value and the currency value from the futures market.

How Do Carry Trades Work?

When you buy and sell a currency pair, you’re simultaneously buying one currency pair and selling the other currency pair. Just like other financial markets, prices in the forex market use a two-way quote system. In the two-quotation system, the first currency quoted is the base currency, while the second currency is the quote currency.

Currencies have different interest rates because interest rates vary among countries.

Forex traders are charged an interest rate on the currency sold and are debited interest rates on the currency bought. In this regard, if an investor wants to take advantage of the carry trade he must buy the currency with a high interest rate and short the currency with a lower interest rate.

Below we’ll break down the step-by-step process behind the carry trade:

1. Carry trade involves two currencies
2. The carry currency – is the high-yielding currency
3. The funding currency – is the low-yielding currency
4. Forex traders short (sell) the funding currency and go long (buy) the carry currency

Example Of A Carry Trade

If, as of Dec 2021, the national interest rate for the two currencies that makes up the AUD/USD pair is as follows:

• In the USA, the benchmark interest rate set by the FED is 0.25%
• In Australia, the benchmark interest rate set by the RBA is 0.10%

The interest rate differential between the two currencies is 0.15%. A positive carry trade strategy would be to go short or to sell the AUD/USD FX pair. By going short AUD/USD, you’re basically selling Australian dollars and buying U.S. dollars. The 0.15% will be paid out daily after the 5:00 PM rollover time in New York. The amount debited in the form of the rollover fee will also depend on how big your forex position would be.

The rollover formula is as follows:

Rollover = Position size * (Base currency interest rate – Quote currency interest rate)/365 x Exchange rate

The AUD/USD exchange rate as of 19 Dec 2021 is 0.7737.

Now if you open a short position with a standard lot of 100,000 units at 0.7737, you have the potential to gain USD 0.31 per day for the entire time the position is held open.

Rollover = USD 100,000 X (0.10% – 0.25%) / 365 X 0.7737 = USD -0.31

Although USD 0.31 seems like a small amount, when leverage is involved and the position is held open for the long term, over time it can provide a substantial interest income.

Next, we’re going to discuss how interest rates affect currencies.

How Interest Rates Move The Forex Market

Central banks’ interest rates are the main market forces and drivers of currency exchange rates. Ultimately, interest rates will determine the long-term trend of a currency pair. At the most fundamental basic level, we have a strong correlation between the foreign exchange market and the interest rate set by a central bank.

As a general rule, this is the relationship between interest rates and foreign currency rates:

1. A high-interest rate tends to cause an increase in the value of the country’s currency
2. A low-interest rate tends to cause a depreciation in the value of the country’s currency

When the expected rate of interest changes, the currency will generally follow in line with that change. In this regard, the central bank’s interest rate decisions have the power to alter the exchange rate fluctuations.

Moreover, when a central bank delivers a surprise rate hike or a surprise rate cut it usually has the biggest impact on currency fluctuations and market volatility. This means that the market expectation around interest rates is a key factor in the way interest rates impact the forex market.

The table below outlines the 4 different market scenarios of how interest rate expectations can impact the exchange rate.

Generally, when the economy strengthens, interest rates tend to rise. However, when economic activity contracts, most central banks will try to stimulate their economy by lowering interest rates.

How Often Do Interest Rate Decisions Occur?

The world’s most influential central banks meet 8 times a year to announce their interest rate decisions. The only exception is the Reserve Bank of Australia (RBA) which has 11 interest rate decisions annually.

The Pros and Cons of the Carry Trade

In addition to collecting the interest rate differential that the carry trade strategy provides, another advantage of carry trading consists of the profits that come from currency appreciation.

In the previous example, where we sold the Australian dollar and bought the U.S. dollar, the AUD fell against the US dollar. Therefore, in addition to collecting the USD 0.31 interest payment, you also benefited from the downward move in the AUD/USD exchange rate.

In the global foreign exchange market, smart money will always follow the currency with a higher interest rate. So, broadly speaking you’re trading in the shadow of smart money. This is another major advantage of carry trading.

The Risks Of Carry Trade In Forex Trading

There are also some disadvantages associated with the carry trade strategy. The biggest risk associated with the carry trade is the uncertainty around the foreign currency market. If we have an adverse movement in the exchange rate of the carry pair, any gains from the interest payments can be wiped out and you could lose money.

Secondly, the majority of FX trades are highly leveraged transactions which means that even small adverse movements in the exchange rate of the carry pair can result in large losses.

Lastly, another risk of the carry trade comes from changes in the actual interest rates. Central banks around the world can alter the interest rate of their respective country at any time due to changes in economic conditions.

Forex Interest Rate Trading Strategy

To increase our chances of success with the forex interest rate trading strategy, we need to have a mechanical process put in place. This will enable us to overcome our emotions and give us a grounded base in deciding what the best carry trades are.

Follow these 4 practical pieces of advice to build a winning trading plan around the carry trade.

1) Find a Currency Pair with a Large Interest Rate Differential

The first step of building a carry trade strategy is to find the right combination of currencies that will yield a large interest rate differential. The bigger the interest rate gap between the two currencies is, the bigger the interest payment will be.

How to Choose a Currency Pair?

When we pick a currency, it’s not enough to choose the currency with the highest interest rate. The best currency candidates for the carry trade must come from a country that provides a degree of financial stability.

As of 22 Dec 2021, among the G20 countries, Argentina and Turkey have the highest interest rates, but at the same time, there are higher downside risks associated with the Argentine Peso (ARS) and Turkish Lira (TRY) exchange rate.

For example, the USD/TRY as a carry trade is increasingly less profitable despite the large gap in interest rates between the USA and Turkey. To profit from the interest rate differential between the two currencies, one would have to sell the USD/TRY pair. However, the USD/TRY exchange rate has consistently risen over the past years erasing any gains made from the interest payment.

On the other hand, if you think of trading the EUR/USD as the single most widely-traded forex pair in the forex market, you run into two issues. First, the interest gap between the two currencies is thin and secondly, the EUR/USD exchange rate is not favourable to the carry trade.

The table below is a list of the G20 countries ranked by the interest rate set by the respective country’s central bank.

In this regard, it’s best to look at currencies from countries with stable financial systems. For example, over the past decade, the Swiss Franc (CHF) and Japanese Yen (JPY) have been considered safe-haven currencies for the carry trade due to their low interest. At the same time, popular higher-yielding currencies are New Zealand Dollar (NZD) and more recently the U.S. dollar (USD).

In recent years, interest rates have sunk to historically low levels and are near zero in most developed countries (Eurozone 0.0%, United Kingdom 0.1%, Japan -0.1%, Switzerland -0.75%, etc.). As a consequence, the FX carry trade in 2021 is harder to exploit than a decade ago.

However, carry trading isn’t dead either!

It’s still possible to find good carry trade opportunities as long as we think outside the box.

For example, Switzerland has a -0.75% interest rate and the United States have a 0.25% interest rate. In this regard, if we would like to take advantage of the interest rate differential, we need to buy USD/CHF. Year-to-date the USD/CHF pair has been outperforming other FX pairs, which makes it the perfect candidate for the carry trade.

2) Find a Broker with Competitive Swap Rates

It’s also important to be aware of the fact that the swap rate credited or debited to your forex trading account is not necessarily the interest rate set by the central banks. In this regard, the swap fees vary enormously among forex brokers in Australia and UK and across different forex pairs.

The second critical step you need to take before establishing a carry position is to compare the swap fees among different forex brokers and choose the one that is paying the highest interest rate for the currency pair you want to trade. This is not a market maker.

In the table below you can compare the best carry trade pairs in 2021 and their respective swap fees with some of the best forex brokers.

As of Dec 2021

3) The Best Time to Get into a Carry Trade

The best time to buy into a carry trade is when there is a positive shift in the interest rate policy of one country. A shift in the interest rate policy also means that the currency value will appreciate. When interest rates are rising, the demand for that currency also tends to increase. Make sure you keep an eye on the economic calendar for the central bank interest rate decisions.

The carry trade also works well during times of low market volatility. A low volatility environment tends to attract more market participants into the carry trade as it offers predictable risk-free returns.

4) Hold the Carry Trade for the Long-Term

The basic aim of carry trading is to collect interest payments from high-yielding currencies. Hence, the longer you hold onto the carry trade the more money you’ll collect from these interest payments.

For the carry trade strategy to be profitable you need patience. To trip the full benefits of the carry trade, you need to view carry trading as a buy-and-hold type of strategy. Do keep in mind, however, that in order to protect yourself from short-term adverse price movements you still need to use a stop loss to safeguard your profits.

Check out our guide if you want to understand what stop-loss orders in forex trading are.