Currency carry trades are investing strategies that involve selling one currency with a lower interest rate and using the proceeds from the sale to buy a different currency that is anticipated to yield a higher rate of interest. This two-pronged approach to buying and selling currencies is essentially an attempt to make a profit based on not only the rate of exchange between the two currencies, but also the difference in the interest rates. When conducted under the right circumstances, a currency carry trade can generate a nice profit very quickly.
Along with the exchange of currencies, it is not unusual for the currency carry trade to involve a third action, such as the purchase of a bond. The bond is purchased for the same amount at the currency that was acquired from the proceeds generated by the sale of the base currency. Often, this is an attempt to maximize the amount of return on the interest rate, and to a degree insulate the investor from fluctuations in the currency exchange market. However, this third step in the overall method is sometimes omitted, depending on the aims of the individual investor.
One of the key factors to keep in mind with a currency carry trade is that the investor hopes that the exchange rate between the two currencies will remain more or less stable long enough to realize a return. When this is the case, the investor is likely to earn a credible return, although probably not one that is substantial. However, if the currency that was purchased should fall in comparison to the base currency, the investor stands to lose a substantial portion of the investment.
Choosing to engage in any exchange of currency with an eye toward making a profit off the rates of interest requires careful tracking of the relationship between the two currencies involved. Often, an investor will want to review the volatility demonstrated by both currencies over the last several periods before implementing a currency carry trade. At the same time, the investor would be well advised to evaluate the current economic, political, and other factors that could impact the value of each currency over the next few periods. Failing to do so will usually lead to losing money, rather than making a profit from the currency carry trade approach.