One of the most popular Forex trading strategies is the carry trade.
This strategy capitalizes on the difference in interest rates among countries.
Interest rates differ from country to country.
This means you may be able to borrow money at a low rate in one country and invest in
a country with a higher interest rate.
In this video you'll learn how a carry trade is constructed, how these trades can earn
interest, and what risks are associated with this type of trade.
Let's start with interest rates.
There are many factors that influence interest rates, such as economic growth and inflation.
These factors can change depending on a country's monetary policy.
Monetary policy is when a country's central bank manipulates short-term interest rates
to help promote economic growth, maximize employment, and maintain steady consumer prices.
For example, if Japan's central bank is trying to stimulate the economy, it will reduce
interest rates to encourage borrowing and spending.
At the same time, the Bank of Canada may be concerned about rising inflation.
To combat inflation, Canada's central bank may choose to raise interest rates.
This will encourage people to spend less and invest or save more.
So how does this work?
Let's run through a simplified example to illustrate the concept.
Suppose a trader borrows money from Japan for 1% and invests in Canada for 3%.
If a trader bought the CAD/JPY currency pair, he is long the Canadian dollar and short the
Japanese yen.
Basically, the trader is borrowing money from Japan and investing it in Canada, which creates
a carry trade.
The carry trade in this example resulted in the trader earning 2% interest.
Each day the trader will receive the interest earned and it will be added to whatever profit
or loss the trader experienced from the currency pair's change in price.
The carry trade is one reason interest rates are so important in the forex market.
When a divergence of interest rates occurs, billions of dollars are commonly redirected
to capitalize on it.
This influx of investment will commonly drive up the value of the long currency and drive
down the value of the short currency.
In our example, this means we would expect the Canadian dollar to rise in value against
the Japanese yen.
However, there's no guarantee that a currency pair will appreciate.
For example, if a policy change was enacted and the Bank of Japan pushed interest rates
higher, the pair would probably depreciate.
Even if the divergence in interest rates remained significantly high, the interest gained could
be offset, or even overwhelmed, by price depreciation.
Consequently, many traders only focus on carry trades when the price trend is in their favor.
The expectation is that this will reduce the chances of the price moving against them,
canceling the benefits of interest payments.
Adding to the complexity, some currency pairs must be shorted in order to collect the interest
payment.
If the European Central Bank was paying 1% and the U.S. Treasury was paying 3.5%, you
would have to short the EUR/USD pair to collect interest.
It's also important to realize that when trading a currency pair, you may be required
to pay interest.
For example, suppose our trader wants to trade an upward trending pair.
To do this, he'll have to cut into his profits because he'll be required to pay interest.
Traders should check with their dealers to clarify which accounts are available to collect
interest.
Understanding the influence of interest rates on currency pairs can help you determine which
pair to trade and how to potentially increase returns by collecting interest.