Carry trading in foreign exchange and investments refers to the practice of investors, speculators and carry traders taking advantage of and utilizing the opportunity to invest of the interest rate differences in two or more countries; they buy or borrow currency from the low interest rate country and invest it at the high interest rate country. By doing this, they get profits of their trade or investment.
Carry trading is a highly risky business which is rewarding to the investor or carry trader. First, the business is dependent upon the interest rates which are not necessarily determined or influenced by the market forces, but by the government through the central bank. Monetary policies and actions by the central bank may positively or negatively affect carry trade.
Central banks act to maintain the value, to revalue or devalue the country’s currency, deal with inflation to stabilize prices and may also act to either increase or decrease the commercial and other financial lending interest rates. This may cause the exchange rates between the currencies of two countries to fluctuate often. Carry traders who engage in this business must be ready to accept this real risk. Carry trade business may lead to losses if a central bank drastically reduces the interest rates. It may also be highly profitable and enable the investor or carry trader make super normal profits when the central bank acts to increase the interest rates.
Selection of a currency pair is very important and vital in carry trading; in fact, the amount of profits an investor or carry trader makes depends on his or her currency pair combination. Normally, anyone engaged in this trade should buy the high interest rate currency and sell the low interest rate currency. Usually, stronger economies have stronger currencies and carry traders will buy the currency with the stronger economy and selling it through the weaker economy. A good combination which may be profitable to a carry trader may be Great Britain, Pound and Swiss Franc currency pair or a United States dollar and Japanese Yen currency pair.
Carry trade is also dependent upon the currency liquidity rate. A currency with higher liquidity rate will be far much profitable to combine with a currency which has lower liquidity rate level. Those carrying on carry trade should inquire about the volatility and economic stability of the country they want to invest or carry trade in. Volatility is the uncertainty about the level of prices and interest rates and may be caused by natural calamities like droughts and earth quakes or wars and civil strife.
Whenever an economy turns volatile, foreign investors and traders will usually leave and avoid investing there. This will negatively affect investment in and eventually the currency value of the volatile economy. Carry trading in volatile economies is not good and may lead to huge financial losses.