profiting from interest rate differentials

The second consideration is the likelihood of appreciation of one currency versus the other. Since carry trades tend to be longer-term positions, a combination of fundamental and technical analysis is often used to arrive at this forecast.

For the best carry trade scenario, you will want to choose the highest interest rate currency that stands the best chance of appreciation against the lowest interest rate currency according to your forecast for the future exchange rate over your time frame of interest. One currency that has a high SWAP rate currently would be CNH which on a short SWAP you can earn a high return of pips (currently 2.7 with the broker I am using)

Things to look out for

Rollovers of currency positions tend to be executed automatically by most online forex brokers if the position is held over the time of 5 PM Eastern Standard Time (New York Close).

An automatic rollover means that the broker will automatically close out your existing forex position for value spot and roll it forward for value one additional business day in the future. Since rollover rates can vary substantially among forex brokers, make sure you choose a broker with competitive rollover rates if you intend to put on carry trades.

Generally, when forex traders have their currency positions rolled, they will get paid pips to do so if they are holding the higher interest rate currency. On the other hand, if they are holding the lower interest rate currency, they will pay pips away when their position is rolled over.

Hedged Carry Trades

Another type of carry trade involves hedging one long carry trade with another short carry trade using different currency pairs that are closely correlated and which results in a net interest rate benefit to the overall position.

For example, a hedged carry trader might exploit interest rate differentials between well correlated currency pairs like the following:

  • EUR/USD and USD /CHF

Such hedged carry trades are often highly leveraged to make them worthwhile, thus much more risky. Nevertheless, the main risk to this hedged carry trade strategy arises if the correlation between the pairs breaks down for some reason and subsequently results in losses. Remember that the correlation risk is of course not the only risk factor to consider, just one of them. The main issue with this is that with many brokers the differentials will be so small that they will not be worth trading so this strategy does not work as well with retail brokers.

Calculating SWAP

In the above contract spec for EUR GBP you have a long / short of -2.81/0.65. Now if you trade 1 lot long you would be paying £2.81 and short you would be receiving £0.65. You would then need to convert that back to your base currency to get the daily SWAP. If you are trading less than 1 lot such as 0.4 lots you would divide the figure by 100 and then times by 40.

Formula = Rate X Lot Size /exchange rate (back to base currency)

Since carry traders basically look to capture the interest rate differential between two currencies, as well as hopefully some additional appreciation from favorable exchange rate movements, they need to choose their pairs wisely based on two primary criteria.

The first is the magnitude of the interest rate differential itself. The absolute value of this differential can be readily computed by subtracting the higher interest rate from the lower interest rate for each currency involved. The interest rates used will be the Interbank deposit rates for the time period during which the carry trade will be kept on for. For MT4 traders you will want to look at the SWAP rates for different pairs which should be viable on the platform. For how to calculate SWAP please see bottom of page.

Contract Specifications