MetaTrader

James Chen, FX Solutions, www.forbes.com

Many analysts have recently been quick to declare the demise of the currency carry trade. They point to the almost 5000-pip exchange rate collapse in the carry-traded Australian dollar/Japanese yen currency pair (among others) within the last three months as evidence that this formerly lucrative practice has finally met its end. It could very well be a blessing in disguise.



AUD/JPY Weekly Chart (Source: FX Solutions-FX AccuCharts)

The recent market turmoil may soon present a potential opportunity for aspiring carry traders, with the Australian dollar now so cheap and still an impressively high-yielding currency, and with reports of likely Japanese intervention on the improbably strong yen.

As the chart below displays, AUD/JPY had been enjoying a healthy long-term uptrend before unceremoniously plummeting in September and October when global financial troubles began intensifying and extreme risk aversion came back into the markets. It is precisely this type of a massive, unprecedented drop that now puts this and other yen-based, carry-traded currency pairs in a much more favorable light. Buying low has perhaps never held more meaning than it does now with these prospective long-term plays.


When investors' risk aversion is not exceedingly high, international capital tends to flow naturally toward higher-yielding currencies like the Australian dollar, thereby contributing to a general exchange rate appreciation in these currencies at the expense of the lower-yielding currencies. When risk aversion increases, as it has in an exaggerated manner recently, capital tends to flock in the opposite direction toward the lower-yielding currencies like the Japanese yen. It is during these times of high risk aversion that we may witness massive unwinding moves like what we have seen recently in the AUD/JPY, where countless carry traders who were holding the pair were invariably shaken out of their positions for substantial losses.

The basic concept behind carry trading is to buy a currency with a high interest rate while simultaneously selling another currency with a low interest rate. The net effect is that the trader earns a high positive yield based upon the differential between the two interest rates. For example, a foreign exchange trader may buy the AUD/JPY currency pair, which is a frequently carry-traded pair due to the traditionally wide interest rate differential between the Australian Dollar and the Japanese Yen.
Special Offer: Larry Kudlow may tease Gary Shilling about being bearish, but Gary was right! The housing market crashed, banks went under, and now the government is here to save the day. Think the problems have passed? Think again, before you invest. Click here for advice to keep your wealth with Gary Shilling's Insight.

Buying the AUD/JPY pair is equivalent to buying the high-yielding Aussie (at a current central bank rate of 6.00%) while simultaneously selling the low-yielding yen (at a current rate of 0.50%), for a current positive interest rate differential of a whopping 5.50%.

Another way to look at a long position in AUD/JPY is the concept of borrowing the yen (low interest rate) in order to buy the Aussie (high interest rate). Either way, the result is the same: The trader earns the high rate while paying the low rate, or earns the differential between the two rates. Because of the highly leveraged nature of foreign exchange trading, the resulting interest earnings can be surprisingly substantial, as the daily interest calculations are based upon the entire leveraged trade amount.

The great risk with carry trading, of course, is if the exchange rate moves significantly against one's entrenched position, much like what we have seen recently on the AUD/JPY chart. In cases like these, losses incurred on the exchange rate's adverse moves can far eclipse any interest rate gains, even those that have been accumulated over a prolonged period of time. It is precisely for this reason that entry timing is so vitally important in carry trading.
Market meltdowns create opportunities to lock in fat yields, like Chevron at 4.2% and Freeport McMoran at 8.0%. Click here for a dozen more buys in Dow Theory Forecasts.

A long carry trade entry at a historically low price point is very difficult to come across. Very soon, that rare opportunity could likely present itself. Currency pairs like AUD/JPY may soon be ripe for re-consideration as potential long-term carry trades with optimal entries near historical lows.

Furthermore, even with expected changes in central bank interest rates, the rate differentials between currencies like the Australian dollar and the Japanese yen are sufficiently wide that there may likely be a substantial differential for the foreseeable future.

With opportunistic entry timing and prudent risk controls in place, carry trading may once again be an exceptional way to earn both interest rate earnings and exchange rate profits in the currency markets.

James Chen is chief technical analyst at online forex broker FX Solutions. He is also a commodity trading adviser. His upcoming book, Essentials of Foreign Exchange Trading (John Wiley & Sons), will be released in early 2009.