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Why is the FX carry trade on average profitable?


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Let’s make it specific. You borrow 100 CHF for a year, convert to 138 NZD, and deposit them in a New Zealand bank for a one year term. You are promised 141 NZD after the year and need to repay 99 CHF. If the exchange rate stays the same, you make a profit of 3.17 CHF, or 3.17% on the notional amount (say 30% return on equity if you lever 10:1). If CHF strengthens more than 3.17% (actually 3.21% to be precise) versus NZD, you lose, if CHF strengthens less than that amount or weakens, you make money.

If you look at these trades historically, you find that doing trades with positive carry consistently makes money, with very strong statistical significance, especially if you make some simple adjustments to the calculation. Moreover, the same carry effect works in other asset classes, so it appears to be a feature of financial markets rather than some specific FX issue. While it’s true carry trades tend to lose money at bad times for global assets in general, so some investors will pay a premium to avoid those losses at the most painful times, this effect cannot come close to explaining the size of the average profit in these trades. Other explanations, like expected inflation rate differentials, credit risk or regulations are also too small.

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The mechanism is straightforward. People want CHF in the future more than they want CHF now, people want NZD now more than they want NZD in the future; and these differences hold even if you adjust for inflation, risk and other factors. You can tell a story about lots of young people in New Zealand with small incomes but big dreams, starting families and businesses and expecting to be rich in the future; while Switzerland is populated with rich people whose dreams are behind them, with plenty of money today they expect to spend in the future, and prospects of declining earnings in the future due to retirement. Those stories are not precisely true, of course, but they capture the essence of why people want to borrow money to spend today in New Zealand, and other people want to lend money to spend tomorrow in Switzerland.

The natural question is why market forces don’t close this opportunity. Why don’t banks open deposit-taking branches in Switzerland where they pay negative interest, and lending branches in New Zealand where they can charge high interest? Why don’t people with Swiss francs invest them in New Zealand, and why don’t New Zealand borrowers come to Switzerland for their money? We understand why normal people don’t do this, but why don’t clever intermediaries jump in to compete away all the profit? Why do hedge funds and a few other aggressive investors reap all the benefits?

I think the answer is that the profits are not as easy as my first example suggests. There are many pitfalls in the carry trade. I knew a chief risk officer of a major global financial institutions who had all his subordinates stand up and repeat in unison, “I hate the carry trade.” It’s a bit like hauling explosives. You get paid more per ton-mile than you get hauling nuts and bolts, more than enough to pay for the occasional disasters. But that’s only true for the people who are best at doing it. If everyone with a pickup truck offered to do the hauling, they would not find it profitable (and no one would tailgate pickup trucks).

To be successful at the carry trade, you need a certain kind of capital. You must be able to call it up quickly when there are good opportunities, and return it, or deploy it to other uses when there are not; and it must be locked up during volatile bad times. If you try to run a consistent amount of money in carry, you’ll have too much in the bad times and not enough in the good times; and if you have weak hands, forget it. You need excellent counterparty relationships, better than you are likely to get if you only trade carry. You need analytic and execution infrastructure, probably more than you can amortize efficiently over just carry trade profits.

Therefore, a relatively small amount of money from the most sophisticated investors captures nearly all the carry trade profits. Less sophisticated investors who try it generally blow up.

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There are some important and basic guidelines for starter investors. Every starter investor should follow all the basic and important guidelines. If anyone comes into the forex market and start trading without any preparation or knowledge then he/she can't survive in the forex market. Proper guidelines, strong knowledge. 

A reliable broker is very important for a trader to earn money from the forex market. I always try to gain more knowledge and follow proper guidelines. My broker Forex4you helps me a lot. They are very helpful and supportive. They never make disappointment to their client.
 

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23 hours ago, Sam Patrick said:

There are some important and basic guidelines for starter investors. Every starter investor should follow all the basic and important guidelines. If anyone comes into the forex market and start trading without any preparation or knowledge then he/she can't survive in the forex market. Proper guidelines, strong knowledge. 

A reliable broker is very important for a trader to earn money from the forex market. I always try to gain more knowledge and follow proper guidelines. My broker Forex4you helps me a lot. They are very helpful and supportive. They never make disappointment to their client.
 

Those Forex traders who are Newbie must understand that trading needs more funds so they have to first of all do some practice in the Demo trading accounts.

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