Carry Trade

What is Carry Trade?
In short, Currency Carry Trade is a strategy where a trader buy a currency with higher interest rate, while selling another currency with lower interest rate. The trader will gain some interest from the differences between 2 currency.

Can it be substantial?
Yes. Let's say AUD/USD conversion rate is 1:1. You borrow 10000 USD from brokerage/bank, and buy 10000 AUD. AUD interest rate = 4.75% annually, and USD interest rate is 0.25% annually. After 1 year, if AUD/USD conversion rate is still 1:1, then you will get 475 AUD from interest, while paying 25 USD to brokerage/bank, making you have a net income of 475-25 == 450. 450 / 10000, only 4.5% return annually, not very attractive, which can easily being beat by ETF and other hedge fund. But almost all currency broker house provide leverage, from 50:1 up to 200:1. Let's take medium, leverage = 100:1, which means u can deposit USD 100 into your account, and holding a LONG 10000 AUD/USD position. Let's says after 1 year the conversion rate didn't change, you will have USD 450 for this carry trade. 450 / 100 = 450%. Awesome right? But please take currency fluctuation risk into consideration. If after one year, AUD/USD conversion rate drop to 0.97:1.00, by holding such position, actually you only earn 450 - 300 = 150, which is 450 from interest income and 300 from currency lost. Needless to say if AUD/USD drop to 0.90:1.00, which actually you lost 550 (450-1000). Of course if the conversion gain, let's say AUD/USD = 1.10:1.00, you will have double income, 1000 from currency gain and 450 from interest.

Strategy
For this case, we ignore short-term currency fluctuation, and only focus on interest income and long-term trend. With FED crazily printing USD to save US economy, everyone would agree that for long-term, USD is going down for a very solid reason. With all the hot money around the world, the commodity (Gold,silver,metal) price will shoot up. And AUD is well-known as commodity currency. So, for long term, high possibility AUD/USD pair will be up trend.

Current position
With 3000 SGD in the account, I am holding 10000 AUD/USD pair, with price around 0.9700. Earning around 1.3SGD interest pay day, by excluding currency fluctuation factor, I would make 1.3*365 = 474 SGD after a year, which is around 474/3000 = 15.6% annually. I am using Oanda as my currency broker house, which allowed leverage until 50:1. So by this position, (LONG 10000 AUD/USD), it only cost me around 270 SGD as deposit. I can always add up my AUD/USD position when AUD/USD pair drop.

Potential Risk
1. US hike interest rate. This will kill off some of the profit from carry trade, since the interest different between 2 pair is narrowed. This is unlikely to happen in short term, since US economy is just start picking up, FED would not like to kill off this bubble so soon.

2. AUS reduce interest rate. This is unlikely to happen too, since the inflation pressure at AUS is high. Unless, AUS hit by a major natural disaster, such as earth quake, flood, tornado, etc, which force the AUS to reduce interest rate to boost the economic, just like what New Zealand had done recently, after NZ hit by major earth quake at Christchurch.

3. Commodity price collapse. Unlikely to happen in short term, since all the hot money have no where else to go to.