A forex carry trade involves getting a loan in a currency which can be borrowed at a low interest rate and then investing that money in long positions in a currency which delivers high interest yields.
In this forex trading practice, profits are earned through interest earned rather than through fluctuations in currency value (see also: Arbitrage).
Example: The going debit annual interest rate for loans in currency A is 4% and the going credit annual interest rate paid by banks on deposits of currency B is 8%. A trader takes out a loan from their currency broker in currency A and uses the money to buy currency B. The hold currency B and earn 8% interest per annum. They use part of the credit interest which they earn on currency B to pay the debit interest on their loan in currency A, and keep the difference as profit.
Interest rates are primarily determined by the general interest environment surrounding a currency, which in turn is largely determined by central banks and the economic and political situations in countries where currencies serve as legal tender. Because these influencing factors do not normally change very quickly, currency carry trades are well suited to longer term forex investments.
However, investors in currency carry trades run the risk of losing money if major currency fluctuations occur. But they also stand to gain if rates develop positively. As a general rule, the higher the volatility of a currency, the higher the interest paid on deposits in that currency.
Both interest rates and the volatility of currency pairs should be accounted for ahead of currency carry trading.
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