For every currency, there is an overnight lending rate issues by the respective currency central bank.
Low interest rate leads the devaluation of a currency.
When the currency’s interest rate goes up, it makes sense that one will make more money by just holding it. Therefore, when the currency’s rate rises, more traders will buy that currency, leads to the scarcity of the currency which eventually raise the price of the currency.
On the other hand, when the currency’s interest rate goes down, few traders will want to hold on to the currency especially if they can reinvest the currency with a higher interest rate. As a result, many will start to sell the currency, which leads to over supply of the currency that will eventually bring down the value of the currency.
In view of the above, whenever the central bank or government is making any announcement on their plans to raise or lower the interest rates, markets move violently and it is advisable not to trade during any major news announcement like interest rates.
So what is a Carry Trade in definition?
A carry trade is a trade whereby the trader buys and holds currencies in a high interest rate, such as USA and sells or borrows money from a foreign country where the currency is in a low yielding interest rate market, such as Japan.
If you notice on the left hand side of the site, there is a column on the interest rates by various major central banks.
For example, take for instance, AUD’s interest rateÂ is now paying 4.75% and JPY’s interest rate is now paying 0.1%. If I will to long AUD/JPY pair and carry the trade overnight, my trade will earn me some overnight (4.75%-0.1%=4.65%) interest but if I will to SHORT AUD/JPY pair now and carry the trade overnight, my trade will incur 4.65% interest charges as I am selling a higher interest rate currency to buy a lower interest rate currency.
This Carry Trade is also considered as a long term strategy, i.e. the trade tends to last for weeks or months, by large institutional players. Of course, this strategy ignores the fluctuation in the exchange rate. If there is some bad economics and political unrest in that country or countries, then it will be good to have extra funds to adsorb the big fluctuation to be able to tolerate the margin call.
As for me, I would normally go for buy or long signals on those pair with a higher interest rate like AUS/USD, AUD/JPY, EUR/JPY, NZD/JPY, GBP/JPY pairs. In this way, if the trade goes in my direction and with the extra interest getting from the trades, I will earn even more.