Just as markets that offer the highest returns will attract the most volume, so, too, in the world of international capital flows, nations that offer the highest interest rates will generally attract the most investment and create the most demand for their currencies.
The “carry trade” is a forex strategy based on this reality. Although it is particularly popular among global macro hedge funds, it is actually very simple to understand and execute.
Carry trades involve buying (or lending) a currency with a high interest rate and selling (or borrowing) a currency with a low interest rate. With lackluster equity market performance and progressively lower yields from the U.S. bond market as a result of interest rate cuts by the U.S. Federal Reserve, this strategy’s popularity surged in 2002. As money piled into carry trades, unhedged traders enjoyed earning yield and capital appreciation.
If executed correctly, an investor can earn a high return without taking on excessive risk. However, the chances of loss are great if you do not understand how, why and when carry trades work best.
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