The leveraged carry trade

Now, a 4-percent annualized yield may not sound very attractive, but when you factor in leverage, the profits are noticeably higher (as are the risks). Although many FX firms offer up to 200:1 leverage, we will look at a more conservative example that employs 20:1 leverage.

Let’s say you have $5,000 to invest and decide to put $1,000 of that into a carry trade. The original 4.75 percent yield would earn you $47.50 over the course of the year or approximately $0.13 per day. With 20:1 leverage, the buying power of your $1,000 becomes $20,000. Interest then becomes $950 per year or $2.64 per day on the original investment — a return of 95 percent.

Now here is where we insert the caution statement: This scenario works only if the underlying values of the currencies do not move — which of course is not possible. Currency values fluctuate every second. Therefore, using higher leverage also means you incur the possibility of larger losses. For example, instead of a 10-pip (or point) fluctuation in the euro-U.S. dollar rate (EUR/USD) representing $1, 20:1 leverage magnifies it to $20 — and currencies will fluctuate dramatically.

Between September 2003 and July 2004, the Australian dollar strengthened nearly 15 percent against the U.S. dollar. If you factor in the currency appreciation and interest rate return on leverage, the profits can be sizeable. However, 15 percent depreciation could have just as easily occurred, which would significantly hurt a leveraged trade.

Because most traders engaging in this type of strategy are looking to earn both yield and the appreciation of the currency pairs, the next question is, how do you determine the type of environment in which carry trades will perform well?