Carry Trading can be a way for a Forex investor to reap terrific profits on their investment. A carry trade is when a currency with a low interest rate is sold to purchase a currency that pays a high interest rate. The difference in the interest rate between the two currencies is called the interest rate differential. An example of a carry trade currency pair is NZDJPY. For a credit in Japan you need only to pay an interest rate of 0.1 %. On the capital market you will get for your money 5 % when you invest your money in NZD. We have a rate differential of 4.9 %. This might be not that much, but when we trade with a leverage of 1:100 than we would have 490 % a year.
With a carry trade, there are two objectives. The first is obviously to make money on the interest rate differential. The second objective is to gain a profit from the capital appreciation. If the carry trade pair appreciates in value, it is a better return on the initial investment.
The biggest risk in a carry trade strategy is the absolute uncertainty of the exchange rates. When the interest rates will vary, these variations can cause a carry trade that was an excellent return opportunity to turn sour and become a bad investment which loses money instead of gaining it. What we saw in the last month was that many central banks reduced their interest rates.
Because of this, it is important to look at more than just the interest rates on the currencies before you trade on the Forex market. Looking at the directional bias of the pairs that you are considering is a good way to determine if trading in those pairs is a smart move for you. If the carry trade pair declines more in percentage than the gain in the interest rate, you can still lose money in capital while gaining in interest. This can cause an overall loss even though you are making money on the interest rate differential.