What Does Carry Actually Pay, Next to What the Pair Can Cost You?

[Fairman]

What Does Carry Actually Pay, Next to What the Pair Can Cost You?

Suppose you hold a long position in a pair where the base currency yields 4.0 percent and the quote currency yields 0.0 percent. You hold 1 standard lot, with a notional of 100,000 units, and the pair's annualized volatility is 10 percent.

Compute the carry. Interest differential 4.0 percent on 100,000 is 4,000 units a year, about 11 per day. In money terms that is similar in dollars if the quote is close to a dollar, a few thousand dollars per year.

Compute the risk. One standard deviation of annual movement is 10 percent of 100,000, which is 10,000 units. Over one month, divide by the square root of 12: about 2,890 units.

Compare. Monthly carry income is about 333 units. Monthly volatility, one standard deviation, is about 2,890. The carry equals 11.5 percent of a one-sigma monthly move.

Put differently, in a typical month, price movement has a magnitude about nine times the carry. The carry is the small steady payoff, and the price movement is the dominant source of profit and loss.

A carry trade makes money on average if price does not move against it enough, and it loses in months when the currency falls by more than the interest earned. Over the 4 percent annual carry, a single 4 percent adverse move erases a year.

Add the broker's markup, which reduces the carry actually received.

Your turn: compute the monthly carry and the monthly one-sigma move for a pair you consider holding.

[FXS HongKong Scalper]

The comparison of daily carry with one month of normal movement is the right way to frame it. Using the same numbers, one month of one standard deviation is about 10,000 divided by the square root of 12, close to 2,900, against roughly 330 of carry for the month. So a single ordinary month can wipe out most of a year's interest.

Two points from our own carry book in Asia hours. Brokers rarely pay the full differential: after their markup, a 4 percent spread can turn into 2.5 to 3 percent in swap, so the real ratio is worse than in the example. And the high yielders tend to fall together in risk-off weeks, so holding three carry pairs is closer to one big position than to three small ones.