Good day forex traders and readers.
Have you ever read about the carry trade and wondered what is the carry trade effect on forex? In this edition of TheGeekKnows forex education series, we will provide you with an understanding of the currency carry trade.
We know that the various countries and their respective currencies have different interest rates. Depending on the central banks’ assessment of the economic situation, a lower or higher interest rate might be set. In the currency carry trade, traders are taking advantage of this interest rate difference.
For example if Currency A has an interest rate of 0.25% and Currency B has an interest rate of 2.25%, a trader can borrow Currency A at a lower interest rate to invest in Currency B so as to enjoy the higher interest rate. In this example, the potential interest differential is 2%. Not bad a deal don’t you agree?
Hence as we can see from the illustration above, Currency A would be sold in exchange for Currency B. As far as forex is concerned this suggests that ignoring all other economic, political, etc factors, a currency commanding a higher interest rate would generally rise in value versus the currency commanding a lower interest rate due to demand for the currency with higher interest rate. When the interest rate difference is wider, the greater the effect would be potentially.
Having said so, the market expectations of currencies involves many various factors and considerations and hence i urge that one view the interest differential as a guide rather then the deciding factor for forex trades.