How would you like to live your home for free? Let me use an example of a carry trade to illustrate the point.
You own your own home and have a mortgage with an interest rate of 5.5 percent. Your loan is $500,000 You convince the Bank of Japan to lend you the same amount of money. They charge you 0.5 percent for the loan and ask for $5,000 USD as collateral (100:1 leverage is the standard for retail forex traders). You now have $500,000 USD worth of Japanese yen. You then convert the Japanese yen into Australian dollars (AUD) and deposit the money into a bank in Australia.
Australian banks pay you 7.25 percent interest. Not too bad. However, you must pay for your loan for the yen.
You then use the profit from the interest rate differential to pay the interest on your home’s mortgage.
You earned 6.75 percent from your AUD/JPY carry trade. Your home’s mortgage costs you 5.5 percent.You still profit 1.25 percent!
So now your home’s mortgage is free. Not too bad, eh? However, an interest-free loan doesn’t make your home free, does it?
There is more to a carry trade than just interest payments, but it is what fuels the fire. Why? It is because you are earning interest on the leveraged money.
In the above example, you are profiting 6.75 percent (AUD interest minus JPY interest) on the $500,000 in currency you borrowed, not the $5,000 you used as collateral. This ...