Trade Interest Rate Differentials

By selling currencies whose country has a lower interest rate against currencies whose country has a higher interest rate, you can profit from the interest rate differential (known as a carry trade) as well as price appreciation.

That’s like being able to get a frosted cupcake with sprinkles on top! That talks to you! Imagine how delicious that would taste!

Currency crosses offer many pairs with high interest rate differentials that are prime for these types of trades.

For example, take a look at the nice uptrend on AUD/JPY. If you had a long position on this pair, you would’ve made a hefty profit.

On top of that, the interest rate differential between AUD and JPY was huge.

From 2002 to 2007, the Reserve Bank of Australia had raised rates to 6.25% while the BOJ kept their rates at 0%.

That means you made profits off your long position AND the interest rate differential on that trade!

Now that’d be an awesome cash cow right there!

Why do higher interest rates differentials lead to currency appreciation?

When a central bank raises its interest rates relative to other countries, it creates an interest rate differential.

This makes the country’s currency more attractive to investors for several reasons:

1. The promise of higher returns attracts foreign capital.
2. Investors can earn better returns on interest-bearing assets denominated in the higher-yielding currency.
3. This requires them to convert their local currency.
4. Additionally, some investors engage in carry trades, borrowing in low-interest currencies to buy the higher-yielding currency, amplifying demand.
5. As more investors buy the currency, its value increases relative to other currencies in the foreign exchange market.
6. This effect is often enhanced by speculators who may start buying the currency even before rate changes, based on their expectations.
7. Lastly, if interest rates signal a strong economy, which can boost investor confidence in equities (and other assets).
8. As foreign investors seek to capitalize on this positive economic outlook, they may convert their local currency to invest in the other country’s stock market.
9. The strengthening of the currency is always relative to other currencies, not absolute.

Later on in college (if your brain hasn’t exploded with all this forex knowledge by then), we’ll teach you more about carry trade.

We’ll teach you which ones will work and which ones won’t.

We’ll even teach you about a lil’ something called risk aversion. But that’s for a later lesson.