The Carry Trade strategy in forex trading involves buying a high yielding currency and selling a lower yielding currency. In doing this you will capture the interest rate differential.
For example if the New Zealand Dollar has an interest rate of xx and the Japanese Yen has an interest rate of xx. If an investor buys the NZD and sells the JPY they will earn the interest rate differential of xx.
This return does not assume any leverage is used. At 10 times leverage the return on investment would be 10xx.
Yen Carry Trade has been a widespread strategy since the Yen started to trend downwards in 1995.
In a carry trade, an investor borrows in a low interest rate currency such as the USD and takes a long position in a higher interest rate currency such as the Australian Dollar. While the dollar depreciated and the interest rate differential remained such as strategy is profitable.
The three main funding currencies for the carry trade are the US Dollar, the Japanese Yen and the Swiss Franc.
The main recipients of the borrowed funds included the Australian and New Zealand Dollars as well as a number of emerging market currencies.
US Dollar Index went from 120 to 80 in the period from July 2001 to Dec 2004-3.5 years and a loss of 33% – defines the period of the USD carry trade.
In any forex transaction you are simultaneously selling one currency and buying another – you are borrowing at one interest rate and investing at another rate.
A carry trade involving an exotic currency such as the TRY can produce large returns with little or no leverage used. The Turkish Lira has an interest rate of 17%. Investing in exotic currencies is much higher risk but gives you a 17% cushion (minus the interest rate you borrowed at)