The carry trade is one of the most popular trading strategies in the currency market. Mechanically, putting on a carry trade involves nothing more than buying a high yielding currency and funding it with a low yielding currency. The most popular carry trades involve buying currency pairs like the Australian dollar/Japanese yen and New Zealand dollar/Japanese yen because the interest rate spreads of these currencies pairs are very high.
The carry trade is a strategy in which traders borrow a currency that has a low interest rate and use the funds to buy a different currency that is paying a higher interest rate. The traders' goal in this strategy is to earn not only the interest rate differential between the two currencies, but to also look for the currency they purchased to appreciate. Using such a strategy in forex trading will make the most sense if you use a forex broker that provides particularly attractive rates on rollovers for the currency pair trade.
Let us take for example USDJPY; the pair which has gained nearly 14.5% in the year 2013,till to date. Interest rate in US as implemented by the Federal Reserve has been at 0.25% since December 2008.In the same way, the interest rate in Japan as implemented by the Bank of Japan is at 0.10% since October 2010. Hence, by practicing Carry Trade Strategy in this pair, we should long the pair by buying USD and selling JPY, which ultimately would return capital gain of 14.5%. In addition to this, the interest rate differential of 0.15% (0.25% receivable on USD – 0.10% payable on JPY) would be an added benefit. And so, the Carry Trade Strategy on USDJPY since the start of the year, generated 14.65% return in just nearly 8 months.
As the basis of the strategy is the interest rate, one must be thorough with the benchmark interest rates of global central banks. One can find various sites which show the global central banks rates. Moreover, one should also be able to understand the underlying fundamentals behind the interest rate changes. This can be known after thorough economic analysis of both countries where the currencies in the pair are from.
Carry trades also perform well in low volatility environments because traders are more willing to take on risk. What carry traders are looking for is the yield – any capital appreciation is just a bonus. Therefore, most carry traders, especially the big hedge funds that have a lot of money at stake, are perfectly happy if the currency does not move one penny, because they will still earn the leveraged yield. As long as the currency doesn’t fall, carry traders will essentially get paid while they wait.