The Arbitrageur System

How to Trade Forex: The Carry Trade

by Irving Rivera on June 22, 2012 · 2 comments

Trade Forex: The Carry Trade

Last time when we talk about forex arbitrage, we explain how rare the opportunities to establish this trade are. However, there others opportunities available on the financial markets that can still create riskless arbitrage profits. The most prominent being, the cover interest arbitrage currencies carry trade.

What is the Carry Trade?

The Forex carry trade is the investing strategy of buying a high yielding interest rate currency by using the money collected from the short sell of a lower interest yielding currency. For example:

Selling the US Dollars (0.25%) short and utilizing those proceeds to buy the Brazilian Reals (9.75%): 2012

How the Carry Trade Works

The carry trade profit from the difference between currencies’ interest rates (the spread). This is how it works on the long side of the trade let say BRL, you would collect positives interest rate payments (9.75%) while the same time paying negative interest payments (0.25%) on the lower yielding currency USD; This Forex carry trade structure will follow this formula:

Carry Trade Profit Equation:

Profits = interests received – interests paid
+/- foreign exchange rate gains – transactions costs

At least this is the popular believe of how this investment strategy works. However, there is a flaw on this assumption because as we all currency traders and arbitrageurs know, currencies are very volatile and ever changing; and in the past equation there is not any hedging factor involve. Reason why I am going to explain you how to really arbitrage a Forex carry trade by utilizing the covered interest investment strategy.

Covered Interest Arbitrage

In order to hedge the currency pair risk factor of forward appreciation or depreciation of the carry trade; we must enter on a financial agreement (future contract or special structure product) where we can establish a final trading price for the currency; to avoid a capital loss due to the forex exchange rate.

There is no too much difference between the previous carry trade formula and this new covered interest forex arbitrage equation; since the old structure is also known as the uncovered interest arbitrage trade. This is how it would work:

    • The forward contract will protect the investor from an exchange rate loss. A typical agreement will read as follow:

“The seller of this contract promise to the holder; to buy X amount of JPY at the exchange rate of 100:1 to the USD on or earlier of the expiration date of this agreement”

¥ 10,000,000 for $ 100,000

    • In order to bring everything together into context the final profit formula of this covered interest arbitrage trade would look like this:

Covered Interest Arbitrage Profit Equation:

Profits = interests received – interests paid
– (transactions costs + hedging cost “forward contract cost”)
+ foreign exchange rate gains

    • The final outcome of this investment strategy will depend in how the risks factors get resolve by expiration date.

Risks Factors:

    1. The country’s central bank interests rate politics.
    2. The opportunity cost of a possible capital gain if the forex rate move in favor of your position and the hedge prevent you from realizing a bigger gain.

Case Study Time

Develop an excel spreadsheet that can automatically calculate all the mathematical terms required to create a forex trade via the covered interest arbitrage carry trade.

The Bottom Line

Aside from the level of difficulty and the larger sum of capital needed to establish a future currency rate hedge contract. The carry trade can be one of the most profitable investment strategy there is; because it involve the most simple and profitable arbitrage structure I know.

The natural spread between saving and leading interest rates which happen to be my personal favorite arbitrage tactic and the thesis of my arbitrage investment system, the Arbitrageur.

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