Forex Traders, Currency Exchange Interest Rates and Market Inefficiency: the Carry Trade

Forex traders have multiple – it could almost be said infinite – strategies to trade the forex market and to take advantage of market
The “carry trade” is a forex strategy that plays on the fact that different nations, being able to attract a higher flux of capital, and having different level of economical and industrial development, offer different interest rates, some higher than others.
As we saw in Currency Trading and The Forex Capital Markets, this fact, representing market inefficiency, is in turn a trading advantage that can be exploited by forex traders.

The carry trade involve buying a currency of a Country that has a high interest rate and selling a currency of another Country that, on the other hand, has a lower interest rate.
Forex traders are thus able to profit in two ways:
-- Earn the difference in the spread (the difference between the two interest rates) of the two currencies, and
-- Earn form capital appreciation

Usually the spread in interest rates is not very large and can be expected to be in the order of 3% to 4%; however, it should be regarded from the broader perspective of the leverage offered by forex and by the lower risk that, at least compared to other forex trading strategies, this system entails. In fact, when factoring in 20:1 or even higher leverage ratios (some forex traders can trade these currency exchange rate inefficiencies with up to 200:1 leverage)

As we noted below, the carry trade can profit from two sources; however, capital appreciation can work against the forex trader; in fact, if capital depreciate, the forex trader will be losing money on this part of the trade, and at the end of the day it is the sum of the two streams (difference in interest rate spread and capital appreciation/depreciation) that will give the verdict as to whether the overall forex trade was successful or not.
Forex traders performing this type of strategy are obviously looking to earn both yield from the interest rates spread and the appreciation of the currency pairs: it is thus crucial to determine in which Countries (that is, which markets) carry trades will
Produce the higher returns with a level of risk in line with the returns expected by the currency trader.
This is indeed very difficult to answer; certainly, the forex market is driven by fundamental for a large extent, but it is the psychology of people and their swings in mood that most drives the forex markets. Investing in a Country that pays high interest rates is riskier that investing in a country that pays lower interest rates because a developing country, thirsty for capitals and money will want to attract the resources it needs by encouraging investors and forex traders with higher returns for their money. However, such a country has intrinsically a higher risk profile and ultimately it is the forex trader that must be willing to take its chances after carefully evaluating the multiple factors coming into the picture.