The Laptop Investor

What I am going to discuss here is an advanced strategy and one that makes many peoples jaw drop as it seems implausible at first. Enter the Positive Carry Trade; this is done by utilising the Foreign Exchange Market (FOREX).

Typically when you borrow money, ie through margin, loan, mortgage etc you end up having to pay interest. How about if I said you can have the bank pay you to borrow money? Sounds exciting right and you’d think hang on there has to be a catch. Actually in this instance there isn’t however remember I said this is an advanced strategy as there naturally are risks and considerations.

This strategy was previously the realm of institutional investors and large funds and banks. This method of trading is rather unique and a difficult concept for some to follow. In fact this led me to changing Tax accountant as when my accountant saw I borrowed money yet earned interest instead of paying it led her to ask what was going on and how this was possible. I explained the Positive Carry Trade to her and she just couldn’t grasp it. This is my financial Tax accountant I’m talking about here, so that rang alarm bells and I immediately got a new accountant.

The Positive Carry Trade

The Positive Carry Trade works on the FOREX market by entering a trade with two currencies that have differing interest rates. In the post GFC (Global Financial Crisis) environment the interest rates have moved significantly lower and fiscal policies of many countries have seen historically low rates so has made this strategy yield less return and the current panic with the Corona Pandemic has caused interest rates to drop even further.

This trade takes advantage of differing interest rates and due diligence is paramount in making this trade. This trade is entered for the long term, in fact the longer you can maintain this trade the better. So as an example lets pick two countries and their currency pairs that has the widest interest rate differential. One I have always liked is Australia for its higher interest rate and Japan for its traditionally lower interest rate.

As you can see from the diagrams above, Australia has historically high interest rates and Japan low. It’s paramount to understand global macro and fundamental analysis when making this trade.

• AUSTRALIA – Interest Rate 3.0%
• JAPAN – Interest Rate 0.0%

For illustrative purposes, I’ve used interest rates from a few years ago and one that’s typically average. Understand that the low interest rate environment we are in right now is unprecedented.

From the list above we can see Australia and Japan has an interest rate differential of 3%. The way this would work on the FOREX market is to trade the Australian and Japan currency pair (AUD/JPY).

When trading on the FOREX market there typically is leverage involved and the other reason this strategy is advanced is due to its use of leverage. FOREX can be brutal when you get the trade wrong. How much leverage you use is personal choice however I’d never go over 50:1. Some brokers allow leverage up to 400:1 which in my opinion is irresponsible.

So for this trade I’ve got $10 000, so I buy AUD$10 000 worth of currency by selling (borrowing) the equivalent amount in Japanese Yen. Remember I am using 50:1 leverage so my face value on this trade is now AUD$500 000.

Essentially what is now occurring is I am borrowing Japanese currency at an interest rate of 0% and earning Australian interest at a rate of 3%.

It’s incumbent to ensure any brokerage platform you use with their fee structure makes this trade feasible. My broker charges 0.3% interest on this trade, however some can charge 3% or more which means you will end up paying interest rather than earning.

So let’s do the math. The differential interest rate is (3% – 0% – 0.3%) 2.97% which means I earn 2.97% on AUD$500 000. The interest on FOREX trade is paid daily and annualised this comes out to $5148.50. So the net interest on the money you’ve entered into the market is actually 51%. Wow hey, and the reality is on historic terms this yield differential is actually small.

My mentor who introduced me into this trade commenced a Positive Carry Trade on the currency pairs AUD/USD just after the GFC. This is when Australian interest was over 5% and the US dropped theirs to 0.25%. Essentially at the time he was earning the average national wage just through interest earned.

Conclusion

One thing I haven’t discussed as yet is it’s vitally important when entering this trade is never to neglect the capital gain/loss of your position. In other words while the interest rate is very attractive on this, it certainly isn’t if the currency pair you’ve entered is going the wrong direction on you. As an example AUD, GBP are two currencies that have declined in recent times while potentially being able to enter a positive carry trade.

Hence I can’t stress enough this is an advanced strategy and generally seasoned investors will jump on these trades when they present and can cause currencies to appreciate so much that there is no longer a sufficient margin of safety to enter.

The above chart is the Australian dollar after the GFC. So aside from the interest earned there was sufficient capital appreciation. I highlight this as for survival the trade must be on the right side of this, as the amount you earn through interest will never make up for capital losses.

So my mentor did extremely well to be earning significant interest while earning even more significant capital gains on this trade. He remained on the trade for about five or so years until 2014 where the Australian dollar became a weakening currency and made the trade no longer feasible. As long as the currency pairs remain neutral or go positive this trade will always be a winner through interest earned. Like I said however it can take a long time to wait for one of these trades to line up; however we are in interesting times right now with several currencies depressed in value.