This 2022 is being a difficult year for the euro, which has fallen to parity with the US dollar in a difficult context for the old continent. But it has also boosted the potential of a particular trade that has shown strong profitability (up to 29% this year) and low correlation with traditional asset classes. Below we explain how exactly this "carry trade" works and how useful it will be for your trading training.
Let's see... What is a carry trade?
an operation of carry trade It consists of buying currencies with higher profitability by borrowing funds in currencies with lower profitability. This translates into buying those with high interest rates and selling those with lower interest rates. The reason is that the returns of the former tend to exceed those of the latter in the medium term, if both the variations in currency prices and the benefits they generate from the difference in interest rates are taken into account. This carry trade operation involves the purchase of currencies from emerging countries by selling euros, and there are a couple of reasons why it has worked so well: 1. The main interest rates of the European Central Bank (ECB) were negative until the month past, while interest rates in many emerging markets (which were already relatively high at the beginning of the year) have only risen. That has provided a widening interest rate differential for carry traders to profit from.
2. The euro has lost value against 18 of the 23 currencies analyzed by Bloomberg since the beginning of the year. Therefore, traders who have sold the euro have benefited from the fall in its value. If we compare this with the American dollar, which has gone from strength to strength, we will be able to understand why this operation has outperformed the same with the US dollar by quite a margin.
Performance of emerging market currencies so far this year against the euro and the dollar. Source: Bloomberg.
Additionally, investors are betting that carry trades will remain profitable for at least the rest of the year. With the old continent on the verge of recession, the ECB will not be in a position to aggressively raise interest rates. This means that the interest rate gap between emerging markets and Europe is not likely to narrow, which also reduces the euro's growth prospects.
What are the risks of this strategy?
As always, just because the carry trade has worked well in the past does not mean it will continue to do so in the future. And since carry trades (especially the most profitable ones) tend to be crowded, the strategy can take a hit during times of market stress as investors rush out all at once. Emerging market currencies can also be quite volatile. Economic problems in the regions have a history of spiraling out of control, which can lead to major collapses in currency values. Therefore, the interest rate differentials that carry trade investors were benefiting from can lose everything (and more) if the value of an emerging market currency plummets. There may also be a contagion effect. Economic crises in emerging markets have a history of spreading beyond their starting points, causing many currencies to fall at the same time.
Profitability of the carry trade strategy with euros and emerging market currencies. Source: Bloomberg.
Lastly, forex trading is often done using leverage. If we contribute a small amount of capital that expands, our potential profits grow, but it also means that small currency movements in the wrong direction can cause us large losses. If we decide to trade with leverage, we should use it sparingly. It is a double-edged sword for our trading training, but if we know how to use it properly everything will go smoothly.
So how do we implement the carry trade?✍
After having seen how the carry trade strategy works and the benefits and risks they bring to our portfolios, we are going to move on to the practical side to close this valuable lesson for your trading training: 1. We open the page Global-Rates.com to see the latest interest rates set by the world's central banks. Emerging markets listed on the Global-Rates website are Saudi Arabia, China, India, South Africa, Indonesia, Poland, Czech Republic, Mexico, Russia, Chile, Hungary, Brazil and Turkey.
Summary of current interest rates of a large number of central banks. Source: Global-rates.com
2. We choose the first four emerging countries with the highest interest rates. Right now, they are Türkiye, Brazil, Hungary and Chile. 3. Buy the currencies of these four emerging countries against the euro. For example, if we buy the BRL/EUR pair it means that we are buying the Brazilian real and selling the euro. We must allocate an equal amount to each currency pair, in this way we diversify the risk if one of our positions suffers large losses.
Every day that we maintain the operation, our currency broker will deposit the difference in interest rates between the currencies through a mechanism called "rollover". As an added bonus, higher-yielding currencies tend to rise in value relative to lower-yielding ones, as more investors flock to them to benefit from higher interest rates. Now that we have reviewed the benefits and risks of the carry trade strategy; What do you think of her? Do you see it useful for your trading training?