Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 16: Inverse and Leverage Funds]
In a previous installment, investors learned about ways to access the vast, liquid currency foreign exchange market through exchange traded products. While investors may make the obvious choice in taking long or short positions in world currencies, traders can also capitalize on the differences in interest rates between various countries with the “carry trade” technique.
The carry trade strategy is where a currency trader sells a currency with a low interest rate and uses the the profits to buy another currency with a higher interest rate, capitalizing on the difference between rates. As such, the currency ETF trader is expected to follow a type of long/short strategy. [Inverse and Leverage Funds]
In utilizing the carry trade strategy, currency traders apply the same “buy low” and “sell high” concept, except with various country’s yields. Consequently, most carry trades are done with currency pairs.
Potential traders would mix and match low yielding currencies, like the British pound, Canadian dollar, U.S. dollar, Swiss franc and Japanese yen, with a high yielding currency, such as the Australian dollar or the New Zealand dollar.
For instance, the Australian dollar with the Japanese yen or the New Zealand dollar with the Japanese yen are two of the most popular methods to utilize the carry trade. Japan has historically held very low interest rates, which, as of June 2, were at about 0.10%, whereas Australia had a 3.5% rate and New Zealand had a 2.5% rate. [World Currencies]
While emerging market currencies may have very high yields – for instance, the Turkish lira has a 11.5% yield and the Russian ruble has a 5% yield, developing market currencies tend to exhibit high bouts of volatility. Since the object of the carry trade is to hold two currencies to bank on the yield differential, quick currency movements are not desired.
Carry trades typically work best when the market is in a state of low volatility and a central bank raises its interest rates or plans to increase rates. In contrast, traders should be wary of interest rate cuts or central banks artificially depreciate their currency.
While traders may short a low-yielding currency and take a long position in a high-yielding currency, currency investors may also utilize funds that follow a carry trade strategy like the, PowerShares DB G10 Currency Harvest Fund (DBV - News) and iPath Optimized Currency Carry ETN (ICI - News) , which both utilize long and short currency futures to capture the spreads on the risk-free yields between a basket of G10 currencies: Australian dollars, British pounds, Canadian dollars, euros, Japanese yen, New Zealand dollars, Norwegian kroner, U.S. dollars, Swedish krona and Swiss francs.
For past stories in this series, visit our “What is an ETF?” category.
Max Chen contributed to this article.