In the last lesson about the correlation between currencies, we mentioned carry trade, but being a very important topic we’ll discuss this concept further. “Doing carry trade” refers to operations on a currency of a country that has interest rates that are cheaper than those of a country in which one goes to invest in the currency. An example of carry trade could be the sale of a currency A whose proceeds go to buy currency B.
– Country A: interest rate 0.5%
– Country B: interest rate 2%
The benefit of such operations would come from the interest differential between the two countries and therefore between the two currencies. This cost must however be subtracted from the cost of the exchange.
This operation is widely used by financial operators because instead of investing their own money they prefer to borrow. Considering this, if there is a debit in currency A and you buy government bonds of country B, the net profit of the operation will be 1.5% (2% – 0.5%) always net of discount. Therefore, these are transactions that are carried out mainly by large financial operators with large amounts of capital.
You might be upset, but these operations are the soul of the most pragmatic finance.
Let’s Carry Trade!
High-level carry trade will be the prerogative of big financial operators, but that does not mean that we too can’t do it in on a smaller scale. In fact, this operation, as we have described it, can be executed on any currency cross. The fundamental thing, of course, is to identify the right cross on which to execute carry trades. Moreover, we need to identify the right moment to close the position in order to optimize profits.
What do you need to consider for carry trades? Well, at this point you should know: interest rates. Remember that for carry trades it is mainly (or almost exclusively) about interest rates and the difference between two countries of the same currency pair.
What you need now are comparative tables of interest rates of the various countries, which you can get from the network, with up to date data. What we are presenting now is a demonstration table, so get yourself a new table of reference for the day and time you are reading this article. You will find a table that refers to durations of various kinds, such as a table with swap values on a $1,000 contract with a 24-hour expiration.
As you can see from the table, for each currency cross there is a different interest differential. So imagine that between European (ECB) and American (FED) interest rates there is a one and a half percentage point difference. PIPs are the unit of measurement for cross values.
When dealing with currencies, you often hear about currency swaps. Let’s take a closer look at what they consist of.
When subscribing to a currency swap, two counterparts undertake to exchange periodic payment flows in two different currencies (e.g., Euro and Dollar) taking into consideration capital and interest. A swap contract involves:
- An immediate (spot) exchange of a given amount of a given currency in exchange for another currency at the current exchange rate.
- A futures exchange of opposite sign but at the same exchange rate
- The payment of interest by both counterparts of the periodic interest calculated on the amount of the currencies traded
In practice, each counterpart opens a long and a short position. The long position (purchase) yields active interest in the currency of denomination of the long position. The short position (sale) bears interest on the denomination currency of the short position.
What are swap contracts for?
Currency swap contracts are very popular because through these we can pursue different objectives such as:
- Coverage against exchange rate risk, also known as “hedge” or “hedging” which we will discuss in another lesson
- Creation of securities obtained by combining the characteristics of various financial instruments, also called “synthetic” securities
- Change of a liability, transforming the denomination currency and modality of the interest rate
If, for example, we have a loan for $100,000 and we want to hedge against the exchange rate risk, we can enter into a EUR/USD Currency Swap contract (Euro against Dollar) with a notional amount equal to the amount of the loan. In doing so we’ll commit to paying the fixed rate on Euro periodically, obtaining in exchange the floating rate on the dollar. If, for example, the spot rate is €1.25/$ and we pay the $100,000 obtained through the loan to the contract partner, we’ll receive in exchange $100,000 x €1.25 = € 125,000. At maturity, we’ll obtain from the counterpart the dollars we need to repay the capital, in exchange for Euro. With this transaction we will have transformed a variable rate dollar loan into a fixed rate euro loan.
Since the exchange takes place on the basis of the exchange rate at the time the contract is stipulated (€ .25 / $) there is no foreign exchange risk.
Go to the next lesson – Hedging