The real life carry trade

Water Cooler Investing
#1

Hi All -

The carry trade was featured in the level II cirriculum and I had a question about real life implementation.

I spoke with my colleagues and was told that when you trade in the Forex market, you pay the “risk free” rate on borrowed funds (short currency) and earn the risk free rate on invested funds (long currency) automatically through the Forex platform. For example, it works this way on Interactive Brokers - investors are paid the difference in interest between the two currencies.

My question is A) what risk-free rate is used and does the benchmark vary between countries? and B) what if an investor wanted to be long the short-term part of Germany’s yield curve and short the long-term part of the US yield curve (for example)? In other words, there should not be a single rate applied to the interest on the carry trade if we are talking about actually being long/short countries’ bonds.

Thanks.

#2

I don’t think you understand the trade fully. Its pretty simple. Today I can, assuming $1CAD =$1USD are at parity: Short $1,000,000 US 90 day Bills, pay 0.03% over 90 days = $73.97 Long $1,000,000 CAD 90 Bills, receive 0.95% over 90 days = $2,342.46 However uncovered interest rate parity would suggest that this reflects market expectations that the Canadian dollar would devalue enough to make the trade unprofitable upon conversion back to USD. In the carry trade you’ll need to be long some instrument and short another by fact. Mismatching duration adds risk of course, and further complexity. The longer term the trade, the higher the risk.

#3

It’s based on overnight libor for spot forex trading.

#4

Forex.com tells me it’s OIS

#5

Doesn’t need to be OIS. It can be any rate.

#6

Thanks for the reply geo, but I’m not sure you understand my question fully. I completely understand the theoretical carry trade. What I’m saying is, has anyone here actaully implemented one? It seems like Forex platforms make assumptions about the rates applied to the long and short currency as opposed to allowing the individual to select which issues apply.

Thanks guys. Thus far I can not find a Forex platform that lets the user choose which issues to long/short

#7

Yes people do this every day in all types of assets…these days everyone is reaching for yield. Fundamentally the trade is no different than buying a higher yielding bond or selling some puts. Any broker will do this, you mentioned IB and Oanda is a good one for FX. To your point yes all rates are different, brokers be brokers.

#8

Another two cents: As Taleb would say, the carry trade is one where you eat like a chicken and shit like an elephant.

#9

So the IB platform uses OIS by default. Anyone know how to change that? Or would I need a different BD? I guess at this point the question is outside the scope of this forum and perhaps more appropriate for IB directly.

#10

To answer your question, the BM rate shall be determined as per Broker Reference BM rates. For IB search their ref. BM rates
(rates will fluctuate daily)