A number of forex traders have heard of the carry trade and how its relative attractiveness can shift sizeable amounts of international investment funds from one currency into another.

Due to the nature of the carry trade, these large carry trade flows usually benefit currencies with higher interest rates, provided of course that the risk in doing so remains tolerable.

The Nature of the Carry Trade

The carry trade itself is a relatively simple trading strategy that involves an investor going short or borrowing in a currency with a low interest rate. The investor then simultaneously goes long or lends in another currency that has a relatively high interest rate.

In doing so, the carry trader hopes to not only capture the interest rate differential between the two currencies, but also to avoid depreciation in the exchange rate of the higher interest rate currency expressed in terms of the lower interest rate currency.

Another common feature of the carry trade is the use of high leverage to enhance profits gained from the interest rate differential. While using high leverage ratios can indeed result in higher profits, it can also mean higher losses, especially if the high interest rate currency depreciates enough to wipe out any interest rate differential gains earned on the carry trade. In other words, leverage adds higher risk.

What the Carry Trade Exploits

The essence of successful carry trading strategies revolves around exploiting the positive or negative "carry" or the interest rate differential existing between two currencies.

If the carry on a particular forex position is negative, that means you will pay away points to hold the position overnight or for a longer period of time.

On the other hand, if the carry on a trade is positive, then that implies you will pick up points for each day's rollover that you hold the position for.

Rollovers in the currency market generally take place at 5pm New York time. Furthermore, the rollover performed on Wednesday evening is especially significant because the carry trade position is then rolled over the two day weekend, as well as the usual one day period.

Once a carry trade position is established, the carry trader will then need to monitor the forex market to make sure that any losses that might accrue on the position due to appreciation of the low interest rate currency are tolerable within their carry trade plan.

Current Simple Carry Trade Opportunities

In today's currency market, the most attractive currencies to short or borrow in for a carry trade are the Japanese Yen, the U.S. Dollar, the Pound Sterling, the Swiss Franc and the Euro. All of those major currencies presently have interest rates at the 1.00% level or lower.

With respect to major currencies that seem attractive to go long or lend for a carry trade, the Australian Dollar and the New Zealand Dollar now have interest rates at the 3% level or higher.

Some minor currencies are also sometimes used in the carry trade by investors, but carry traders should be aware that going long these currencies usually involves taking a considerably higher degree of risk of that currency depreciating and perhaps even devaluing.

This latter group of minor currencies all offer interest rates over 5% that range up to as high as 24%. They include the Brazilian Real, the Russian Ruble, the Chinese Yuan, the South African Rand, the Indian Rupee, the Singapore Dollar, the Icelandic Krona, the Turkish Lira, the Indonesian Rupiah, the Venezuelan Bolivar, the Argentine Peso and the Hungarian Forint.

Hedged Carry Trades

Yet another type of carry trade involves hedging one long carry trade with another short carry trade using different currency pairs that are closely correlated and which results in a net interest rate benefit to the overall position.

For example, a hedged carry trader might exploit interest rate differentials between well correlated currency pairs like the following:

• EUR/USD and USD /CHF

• AUD/USD and NZD/USD

• GBP/USD and USD/CHF

• EUR/JPY and CHF/JPY

• GBP/JPY and CHF/JPY

Such hedged carry trades are often highly leveraged to make them worthwhile, thus much more risky. Nevertheless, the main risk to this hedged carry trade strategy arises if the correlation between the pairs breaks down for some reason and subsequently results in losses. Remember that the correlation risk is of course not the only risk factor to consider, just one of them.

The Benefit of Compounding Interest

Another interesting element that favors the carry trade is the possibility of compounding your interest on a daily basis by rolling your carry trade positions over each day.

When the rollover spreads available for doing so are reasonably competitive, this can provide even more income for the carry trade compared with just rolling the carry trade position out for an extended period using a forex forward contract.

The Effect of Risk Aversion and Appetite on the Carry Trade

When risk aversion prevails among investors in the forex market and exchange rate volatility is high, the carry trade often starts to look less attractive since the riskier currencies to invest in tend to have higher interest rates.

On the other hand, when all seems well in the world and more stability has returned to the currency market, the risk appetite of investors then tends to increase and they start looking for higher returns on their money, even if it means taking more risk.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.