Markets that offer the highest returns on investment will be the ones that generally attract the most capital. As interest rates rise, investment will follow, which can in turn increase the value of the currency.
On the other hand, the investor also should pay attention to the health of the economy from the currency pair to ensure the market will move to in his favour.
The carry trade strategy is popular among investors and takes advantage of the interest rate differentials between two currencies while also hoping to benefit from the positive trend in the pair.
As an example, you borrow JPY and convert them into USD and invest in cash solutions or in fixed income product for the equivalent amount. Let’s assume that the investment pays you 2% and the Japanese interest rate is almost 0%. The investor makes a profit of 2% as long as the exchange rate remains stable.
Carry trade must be conducted with caution due to potential volatility on the currency pairs. Tension in markets can have drastic effects on currency pairs and can be drained by brutal turn.
For many years, the JPY has been the most favoured carry trade strategy because of its traditionally low or no interest rate governmental policy. By matching the yen with a high-yielding currency from a growing economy, you can earn interest due to the difference in yield. By choosing a nation coming out of a recession and on its way to solid long-term growth with the possibility of rising interest rates, you can expect earn a decent yield.
There is a fair amount of risk to the carry trade strategy mainly related to the uncertainty of exchange rates. Using the example above, if the USD was to fall in value relative to the JPY, then the investor would run the risk of losing money.
When risk aversion prevails among investors and exchange rate volatility is high, the carry trade often starts to look less attractive.
On the other hand, when stability has returned to the currency market, the risk appetite of investors then tends to increase. They start looking for higher returns, even if it means taking more risk.