As we saw with regard to the effects the overall business environment has on currencies, interest rates play a key role. One way to take advantage of interest rate differentials between countries is by buying a currency with a higher interest rate and collecting that interest and then selling a currency with a lower interest rate; when the short position pays the interest rate, this is called the carry trade. In times of global economic expansion, investors and traders make money by using this strategy.
A typical example from a couple of years ago would be buying U.S. dollars and selling Japanese yen; in trading parlance this is known as going long USDJPY. If interest rates were 3.0 percent in the United States and 0.5 percent in Japan, the position would yield, or “carry,” an annual rate of 2.5 percent. If the trader had on a position of long five standard lots, or $500,000, he would collect 2.5 percent annually on the $500,000 even if he had only $10,000 in his account.
That may sound like a lot of money at first, but consider the risk that individual would be incurring to capture that $35 a day in interest. By holding a $500,000 position in a $10,000 account, the trader could lose everything if USDJPY moved just 2 percent. In today’s marketplace a 2 percent move in a single day for a currency pair is not unreasonable. In a much larger account, in a healthy economic climate, and with the account managed by professionals, this arbitrage strategy makes a lot of sense.
Professional traders understand this and have taken advantage of interest rate differentials in the global marketplace during times of economic expansion. For an individual with little experience and a small account, the strategy is inadvisable and dangerous. The last time the carry trade was working, from mid-2005 to mid-2007, it was working very well. Prices of the higher yielding currencies raced higher while prices of the lower yielding currencies stood still or even moved lower.
What this meant was not only that buyers, or “longs,” in the carry trade were capturing the interest on their positions but that they were reaping the traders’ reward as their positions increased in value. Individuals with little experience were accumulating larger and larger long positions and calling themselves traders. You probably can guess how this ended.
Prices plummeted violently at the beginning of 2008 as speculative monies vanished when stock and real estate markets fell sharply after their inflated advances earlier in the decade.
After a long pause through the spring and early summer of 2008, the sell-off accelerated again in mid-2008 as carry traders with only a few years’ experience learned the hard way that what goes up comes down. They also learned that earning a few pips a day on a carry trade was not trading at all.
The bright side of this situation for experienced traders was that after the carry trade evaporated, two-way trade resumed. After the majority of the speculative money was wiped out, prices were free to move up and down, which is what markets do in normal conditions.