Carry Trade Explained - How Forex Trading Makes Money Long Term

The carry trade is one of the less understood ways to make money investing, but ultimately is used by all of the largest, most sophisticated investors to preserve wealth and diversify risk amongst economies. I took time out to write a series of articles about the carry trade, and forex trading in general. Here is a brief piece published around a week ago which scratches the surface with more information available via links at the end of the article.

Carry Trade Explained
By Steve B Wise
The carry trade explained as it relates to interest rate differentials between countries is the most common use of the term in actual market practice. The concept begins fairly straight forward like any other investment. Raise capital (either borrowed or equity) and then lend it at a higher rate somewhere else. The carry trade explained this way does not obviously capture all of the complexity of the mechanics of actual trades however it does help to start trying to understand the position from its basic roots: interest rate differentials.
How a Typical Investment Might Be Established
Among the most common uses of rate difference trading is leveraged borrowing of large quantities of one foreign currency (and paying one interest rate) and lending/investing a different currency (in the same gross quantity) in another currency at a different (higher) rate. This results in a rate gap (owed versus earned) which nets the investor a small amount of profit per dollar invested daily. Generally this amount is quite tiny on a dollar for dollar investment, which is why investors typically use very high leverage to increase the daily profits to a meaningful amount.
Carry Trade Explained: How Leverage Makes Rate Differentials Worthwhile
Note that while we mentioned a moment ago the amount of profit on a dollar for dollar equity investment in a forex interest rate differential trade is small (a $10000 investment might yield $1.20/day), when leveraged up to a typical high water amount of 100:1 leverage that daily profit becomes $120/day, a typical living wage in the United States. In truth most investors will go with something more conservative like a 10:1 ratio or perhaps 20:1 (making a $100,000 equity holding pay out the same $120/day at 10:1).
What Forex Pairs Are Used in Interest Swaps in Today's Market
Trade positions typical in today's market are spoken of as going long AUD/JPY or alternatively long AUD/USD, meaning borrowing at today's low rates in the United States and Japan, then lending that same dollar amount in Australian dollars collecting a daily fee along the way.
See a detailed example of the carry trade explained, including a forex margin account example.
Steve B. Wise
Article Source: http://EzineArticles.com/?expert=Steve_B_Wise
http://EzineArticles.com/?Carry-Trade-Explained&id=5272141

I hope this carry trade explanation whet your appetite for more information on this high yield / high risk investment strategy. While the leverage involved in trading forex is quite high, the rewards can be substantial and consistent when managed appropriately. We'll be making up a couple of these carry trade positions in the not too distant future and when we close them we'll share the results.

Learn more about Forex Trading