- By being long the higher-yielding currency and short the lower-yielding currency, you can earn the interestrate differential between the two currencies, known as the carry. If you have the opposite position — long the low-yielder and short the high-yielder — the interest-rate differential is against you, and it is known as the cost of carry.
- Spot prices appreciate in the direction of the interestrate differential. Currency pairs with significant interestrate differentials tend to move in favor of the higheryielding currency as traders who are long the high yielder are rewarded, increasing buying interest, and traders who are short the high yielder are penalized, reducing selling interest.
The catch is that downside spot price volatility can quickly swamp any gains from the carry trade’s interest-rate differential. The risk can be compounded by excessive market positioning in favor of the carry trade, meaning a carry trade has become so popular that everyone gets in on it.
Carry trades usually work best in low-volatility environments, meaning when financial markets are relatively stable and investors are forced to chase yield. Keep in mind that carry trades need to have a significant interest-rate differential between the two currencies (typically more than 2 percent) to make them attractive. And carry trades are definitely a longterm strategy, because depending on when you get in, you may get caught in a downdraft that could take several days or weeks to unwind before the trade becomes profitable again.
For Dummy : Carry trade strategies basic
