A currency trading/ speculation strategy that involves borrowing in low-interest currencies (low-yielding currencies) in order to invest in high-interest currencies (high-yielding currencies). This strategies is based on two currency pairs (known as the carry pair), with the high-yielding currency being the first in the pair. A carry trade is constructed as follows:
Carry trade: Buy high-yielding currency + Sell a relatively lower-yielding currency
Traders who long the carry pair will receive the difference in interest rates between the two currencies. Therefore, a widening interest rate gap will attract more traders and investors to enter carry trades, and vice versa. As a rule of thumb, the wider the interest rate gap between the two currencies, the more profitable carry trade will likely be.
In general, traders will not have to worry about movements in exchange rates. The return to currency trading/ speculation can be substantial over the long term. However, should market sentiment reverse due to changes in market fundamentals, carry traders may opt to liquidate their long trades, fearing that the high-yielding currency would depreciate.
Carry trades must be used as a long-term strategy, and should only be contemplated by trades who are not concerned about keeping their long positions for a long period of time (usually from a few months to a year or so).
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