As we have learned in our first two lessons on the carry trade, it is the size of the difference between interest rates in the countries whose currencies we are trading that ultimately determines how much we either pay or receive for holding a position past 5pm New York Time. With this in mind it is only logical that if the difference in interest rates between two countries changes, then so will the rollover amount that is either paid or collected when trading those country's currencies.
As a quick example lets take another look at the NZD/USD. As of this lesson if we were to buy the NZD/USD currency pair then we would earn $10 for each contract we held past 5pm NY time. As we have learned in our first two lessons the reason why we would earn $10 is because we are long the NZD where currently interest rates are at 8.25% and short the USD where interest rates are currently 2% as of this lesson. So with this in mind we are long the positive interest rate differential of 8.25%-2% which equals 6.25%.
Now lets say in our example that interest rates in the United States went up by 1% to 3%, while interest rates in New Zealand stayed the same. If this were to happen then our positive interest rate differential of 6.25% would drop to 5.25%. Very simply here, as the positive interest rate differential has decreased the amount of money that we earn for holding the position has decreased as well.
Conversely, if rates were to rise in New Zealand and stay the same in the United States then the interest rate differential would grow in our favor, and the amount we earn for holding a position past 5pm should grow as well. So you can see here that one of the first things that must be considered when thinking about a carry trade is what the current interest rates are, and what they are expected to be for the life of the trade.
A second thing which must be considered when thinking about a carry trade is the exchange rate fluctuation that may occur while a trader is in the position. Traders may consider a number of things here, the most popular of which are one of or a combination of:
1. Capital Flows: Most importantly here is interest rate expectations which as we discussed in our lesson on how interest rates move the forex market, when interest rates rise in a country, interest bearing assets generally become more attractive to investors, which will many times drive the value of a currency up all else being equal, and vice versa when interest rates fall.
Notice here that I say interest rate "expectations". As we have talked about extensively in module 8 of our free basics of trading course, markets anticipate fundamentals so in general once an interest rate increase or cut is announced, it has already been priced into the market.
2. Trade Flows: Most importantly here is affects on the current account.
We will be discussing how traders go about forcasting changes in capital and trade flows in the coming lessons. The third thing which traders focus on and which we have already covered in our basics of trading course is:
3. Technical Analysis: As carry trades are generally longer term trades many traders will look at the overall trend in the market and use technical analysis to try and determine when they think the trend is going to be in their favor if they open a carry trade.
This 61-video series is an introduction and in-depth look at the forex market, including how to place trades, the fundamentals of the forex market, profiles of the main currency pairs, and factors to consider when choosing a forex broker.
This is a continuation of The Basics of Trading course by Informed Trades.