When trading currencies, you’re essentially dealing with the relationships between countries and their economies. The interest rate differential between countries plays a pivotal role in deciding which currencies to buy and which to sell.
Markets that offer the highest returns on investment attract the most capital. In the world of international capital flows, nations that offer the highest interest rates (along with solid credit ratings) will generally attract the most capital and create the most demand for their currencies. When you buy a currency, you earn its interest, while you are obligated to pay interest when you sell a currency.
The carry trade is designed to capitalize on the relationship between two countries’ interest rates and currencies. In a nutshell, a carry trade involves buying (or lending) a currency with a high interest rate while selling (or borrowing) a currency with a low interest rate — hence netting a positive interest rate differential. For more information on the mechanics of the carry trade, see “Getting a lift from the carry trade,” Currency Trader, October 2004, p. 32.) Although earning interest rate differentials on the degree of 2 to 4 percent may not seem very compelling, the high leverage available in the forex market makes the carry trade an extremely attractive strategy in the right circumstances.
Using 10 to 1 leverage (1-percent margin), that 2- to 4-percent interest rate differential becomes a potential 20- to 40- percent profit. Of course, leverage comes with risk, which means losses will be exaggerated the same way as profits. Another benefit of the carry trade is the added potential for capital appreciation — i.e., in the form of price gains if the currency you are long gains ground against the currency you are short. The key to the carry trade is determining which countries and currencies offer the most favorable relationship. Recent history has shown how quickly things can change in this respect.
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