The classic version of the carry trade in the currency markets involves going long the three highest yielding currencies and going short the three lowest yielding currencies in the G10 nations.  The same principle can be applied to any two currencies.  Simply go long the higher yielding against the lower yielding.  When you do this you will earn the interest rate differential.  If X nations short term rates are at 8% and Y nations rates are 2% then you can make 6% on the “carry” on the interest rate differential.  When you apply a bit of leverage you can earn quite a bit more.

As with any trade there are risks involved with the carry trade. One of the greatest risks to the carry trade is volatility.  When volatility rises the return from the carry trade declines. In the chart below we have a chart of the DBV which is an ETF that goes long the three highest yielding currencies from the G10 nations and short the three lowest yielding currencies as well as the JP Morgan G7 VIX (we inverted the G7 VIX).  It is obvious that as volatility increases the returns from the carry trade decline.

One idea that we shared with subscribers in our latest issue was to go long the DBV in anticipation of a decrease in volatility. As you can see in the chart volatility has been declining the last few weeks. Based on this and other factors we like this as a short term trade.

Happy Trading,
The Macro Trader

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