Interest Rates & Carry Trading. Interesting Information to Remember
You should learn forex trading using a good proven and tested forex system.Any forex trader knows that interest rates are an integral part of investment decisions and can drive the currency as well as the stock markets in either direction. FOMC rate decisions are the second largest currency market moving release behind the unemployment figures.
The impact of interest rate changes not only have short term consequences but also have long term consequences on forex markets. One Central Banks interest rate change decision can affect more than a single currency pair in the interrelated currency markets.
In forex trading, an interest rate differential is the difference between the base currency and the counter currency interest rate. In the pair, EUR/USD, Euro is the base currency and US Dollar is the counter currency. The interest rate differential for the EUR/USD currency pair will be the difference between the Euro and the US Dollar interest rate.
Understanding the relationship between the interest rate differentials and the currency pairs can be very profitable. In addition to the Central Bank’s overnight interest rate decisions, expected future overnight rates as well the expected timing for the rate changes can be critical to the currency pair movements.Interest rate differentials are considered to be the leading indicators for currency prices. LIBOR and the 10 year bond yields are usually used as leading indicators of currency movements.
Let’s take an example, suppose the Australian 10-year government bond yield is 5.25%. The US 10-year government bond yield is 1.75%. The yield spread in this case would be 350 basis points in favor of the Australian Dollar.
Suppose the Australian government raises its overnight interest rate by 25 basis points. The Australian 10 year government bond yield would appreciate to 5.50%. Now, the new yield spread between AUD and USD is 375 basis points in favor of AUD. The Australian Dollar will also be expected to appreciate against US Dollar.
The general rule of thumb is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against other currencies. This information should be very important for your trading. Use the data available on Bloomberg to keep track of currencies in the currency pairs that you trade.
Carry trading is done by forex traders to take benefit of the basic economic fact that money will flow where it will get high returns. This constant flow of capital between the different markets is what makes carry trading possible.
Carry trading is one of the fundamental trading strategies employed by professional forex traders. Leveraged carry trading is one of the favorite strategies employed by hedge fund and investment banks. You as a forex trader can also benefit from carry trading.
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Carry trading means taking benefit of the interest rate difference between two currencies. Carry traders take benefit of the interest rate differential between two currencies by buying or going long on the high interest rate currency and selling or going short on low interest rate currency.
Lets take an example: suppose New Zealand dollar offers an interest rate of 4.75% while the Japanese yen offers an interest rate of 0.25%.
An investor will want to benefit from this interest rate differential. He/she will buy New Zealand dollars (NZD) and sells Japanese Yens (JPY). He/she can earn a profit of 4.75-0.25=4.5% so long NZD/JPY exchange rate does not change. If the investor can handle leverage and uses a leverage of 20:1, this 4.5% return will be magnified into 90%.
If the currency pair NZD/JPY appreciates, the investor can get a capital gain as well as a yield on the investment. When there is a carry trade opportunity, many investors jump on the bandwagon. The more investors carry trade, the more the currency pair appreciates.
It depends a lot on the mood of the investors as a group. If investors as a group have low risk aversion, carry trading will be profitable. But if the investors as a group suddenly develops high risk aversion, carry trading will become unprofitable.
However, if the low interest currency appreciates to some extent for different reasons, carry trade will become unprofitable. In such a scenario, the more the low interest currency appreciates, the more unprofitable carry trading that currency pair will become.
How do you check the mood of the investors? By knowing whether the currency is overbought or oversold. For this you need to identify the current trend of the currency pair and see whether it is moving in the right direction!
MACD (moving average convergence divergence) indicator can help you in identifying the trend. Enter the trade when MACD crosses the zero line from below and exit when it crosses the zero line from above.
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