Carry Trade

Carry trade is a trading strategy where investors / traders sell or borrow assets with low yielding interest rates in order to fund or buy high yielding assets.
Carry trade involves borrowing in low interest rates (called funding currencies) and investing in high interest currencies (target currencies).
Brazilian Real, South African Rand and Australian Dollar are the examples of recent attractive target currencies.
The UIP condition states that higher-yielding currencies will tend to depreciate against lower-yielding ones at a rate equal to the interest differential so that expected returns are equalized in a given currency.
Popular funding currencies have recently included the US dollar and historically the Japanese yen or Swiss franc.
If the target currency is not less than the funding currency during the life of the investment, the investor earns at least a difference in interest.
This strategy will not work if there is equal interest (UIP).
UIP indicates that high yielding currencies differ in interest rates from low yielding currencies so that the expected profit is equal to a given currency.
Under UIP, any interest gap is expected to be fully covered by currency movements.
A large part of the experimental literary documentation, that UIP almost fails globally on the short and medium term horizon.
In many cases, the relationship is exactly the opposite of the UIP's prediction: high-interest currencies have a value, while low-interest currencies have a low value.
This failure of UIP is so well established that this phenomenon is called "forward premium puzzle".
UIP's failure is no secret to investors; hence the popularity of carry trades.
Carry trade puts pricing pressure on target currencies and downward pressure on funding currencies.
This can result in an increase in the Base Exchange rate moves.
In addition, it could result in a sharp rise in the exchange rate when Carry Trade investors open their positions.
Selling Japanese yen and buying high yielding currencies such as Australian dollar and New Zealand dollar has been a popular carry trade.
For example, if you buy the AUD/JPY, then you sell Japanese Yen (which yields 0.00% a year)and buy an equivalent amount of Australian Dollars (which yields 3.50% a year) simultaneously.
If you stay on that position then you will be charged 0.00% interest a year for borrowing Japanese yen, and receive 3.50% a year for holding Australian dollars.
The interest rate differential of that position is +3.50 (3.50% – 0.00%).
So you may get approximately 3.50% a year on the value of the position, depending on the margin interest charged by the broker and on exchange rate volatility.

 

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