Leveraged Carry Trading Strategy

Carry trade strategy entails buying a high interest rate currency and selling a low interest rate currency. Suppose, New Zealand Dollar NZD offers an interest rate of 4.35% while the Japanese Yen JPY offers 0.35%. Carry trade strategy involves buying NZD and selling JPY. The investor earns a profit equal to the interest rate differential of 4% as long as the exchange rate between the two currencies does not change.

Carry trade is one of the fundamental trading strategies that uses one of the basic economic principles that money constantly keeps on flowing from a low interest market to a high interest market. Markets that offer the highest interest rate attract the most capital. Countries are no different. Countries offering a better interest rate attract more capital as compared to countries offering low interest rate.

Investing in high yield assets is what every investor wants. When a Japanese saver finds that she can get a much higher return of 4.35% on the NZD deposit as compared to getting only 0.35% on her JPY deposit, she will sell JPY and buy NZD.

Of course, she will not be the only person doing this. There will be millions of depositors who would want to profit from the high interest rate offered on NZD. When millions of depositors sell JPY and buy NZD, JPY will depreciate and NZD will appreciate. This exchange rate appreciation also will add to the profits of the carry traders. This is the scenario when the risk aversion amongst the investors are low and they are willing to risk investing on a high interest rate currency. But when risk aversion amongst the investors increases due to some financial crisis and they tend to seek refuge in safe haven currencies, carry trading strategy fails as capital starts to flow from high interest rate currencies to low interest rate currencies.

Now, if you use leverage in carry trading, the profit multiplies. Leveraged carry trade is a popular trading strategy used by the hedge funds. Suppose, you use a leverage of 5:1, the interest rate differential of 4% becomes 20% giving you substantial profits. Increase leverage to 10:1, your profit will soar to 40%.

But, you need to remember that using leverage is a risky business and it is a double edged sword that cuts both ways. When things work well, your profits multiplies by using leverage. But when things don't work well and market takes a turn, your losses also multiply. So before, using leverage you should think twice!

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