How The Currency Carry Trade Works

A currency carry trade involves buying or going long a currency that pays a high interest rate and selling or going short a currency that has a low interest rate.  This is done by purchasing a currency pair.  If the currency pair position is held overnight, the holder of the position is paid the close of trading the difference between the two central bank imposed interest rates for the opposing currencies.

Here is an example of the currency carry trade.  The United States Federal Reserve has set interest rates in the U.S. at close to 0.25% in 2012.  Other countries in the developed world have much higher central bank imposed interest rates due to the fact that they have strong economic growth, such as Australia, where the Reserve Bank of Australia has set interest rates at 3.5% during 2012.  If a currency trader initiated a currency carry trade to make money from this interest rate spread, they would buy the Australian Dollar / United States Dollar currency pair, which would make them long the Australian Dollar and short the United States Dollar.  Each night, upon the close of currency trading, the firm managing their FX account would pay the trader nearly 3.5% for holding the Australian Dollar and would deduct nearly 0.25% for borrowing the United States Dollar.  The currency trader does not earn the total interest rate difference between the two currencies because the FX trading firm makes money by charging fees and charging a spread between the actual interest rates available and what they are willing to pay or deduct regarding interest, which is why it is important to research which FX trading firm to trade with before undertaking the currency carry trade.

While the currency carry trade can be highly profitable, if the spread between currencies remains wide for a long time, it also involves some trading risk, including risk of total loss of investment capital.  The primary risk associated with the currency carry trade is that the currency that one is holding long loses value versus the currency they are holding short, and the principal investment loses its entire value.  Some traders mitigate this risk by initiating a currency carry trade using margin, so that they maximize their earnings from the interest differences between two currencies but limit their downside risk to the amount of money they put up as margin collateral.

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