For example, let’s say that currency A has an interest rate of 1% while currency B has an interest of 5%. In this scenario, investors will borrow an amount X of currency A while placing that received capital in currency B obtaining a return of 5%. In a perfect situation, where there is no movement in exchange rates, the investor will get the return on currency B (5%) minus the cost of borrowing currency A (1%). The performance of the operation will therefore be the product of the difference in the interest rates of both currencies, that is, 4%. (5% -1%).
This technique explains, in part, the movements in the markets in favor of a currency when it experiences upward movements in interest rates. In the same way, it explains how a currency suffers when its official interest rates are subject to a downward revision. Investors move in favour of high-interest currencies to the detriment of those with lower rates.
However, this technique carries a significant risk. The investor is subject, throughout the life of the operation, to fluctuations in the exchange rates between currency A and currency B. If the currency that you have bought suffers a fall for any reason (decline in the GDP of the economy, increase in unemployment in that country, inflation ... etc), the positive return on interest rates may not compensate for the fall in the value of the currency at the time of closing the transaction.
Unfortunately, we don't always have to look at currency returns when taking positions. For example, we observe how the Brazilian real has annual returns of between 11% and 12% while the euro does not exceed 1%. This does not mean that the correct thing is to ask for a loan in euros at 1% and place them at 11% in Brazilian real. Generally, currencies of emerging countries have such high interest rates precisely to combat inflation and the deterioration of the value of their own currency. Therefore, it is probable that if we place our capital in Brazilian real, the risk incurred and the possible fall in the exchange rate will not offset the profitability differential in our favor.
Another clear example is the carry trade between the euro and the Russian ruble in the period 2013-2014. Despite the fact that the yield of the ruble was much higher than that of the euro during this period (7% per year on average), by the end of 2014 the ruble had lost half its value from the beginning.
Ideally, in the case of the carry trade, it is to compare currencies of similar economies, if possible to be leading, and especially currencies without significant risks of collapse and whose economies have reasonably similar inflation levels.
Currently, the best examples of carry trade operations are long positions in USD versus short positions in CHF, EUR, GBP and JPY.
For retail traders, the practical application of this technique consists of looking for the currency crosses that have the currency with the highest interest rate and the lowest interest rate. That is, we will try to position ourselves in a cross that has the highest possible differential, buying the currency with higher interest rates and positioning ourselves lower than the currency with lower interest rates. This will result not only in the search for increases in the exchange rate that favours the purchased currency (high interest currency), but we will also benefit from the daily swap that the crossing has. The daily swap is equal to the rate of the currency purchased minus the rate of the currency sold, adjusted to the days of the position.
As we have pointed out above, the greatest risk that users of this technique face is the variation that exchange rates may have against them during the duration of the operation. The most common is that a currency with high interest rates performs better than one that has lower interest rates. This rule, far from always being fulfilled, is a guideline that investors follow but that requires at the same time to take into account, from a fundamental and technical point of view, the expectations that different currencies may have in order to minimise the risk of our operations.
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