Forex Rates and Interest Rate Differentials

The interest rate differential for a particular currency pair consists simply of the positive difference between the interest rate observed in the country of the first currency and the interest rate seen in the country issuing the second currency. In addition, as a result of international capital flows seeking higher returns, forex rates tend to move in the direction favoring the currency with the higher interest rate.

Furthermore, the concept of interest rate parity refers to the relationship between foreign exchange rates and interest rates. The fundamental tenet of interest rate parity requires that hedged returns from investments made in differing currencies should be equal, irrespective of the actual levels of their respective interest rates.

Interest rate differentials provide the pricing basis for foreign exchange forward swaps and forward outrights, as well as contributing to the theoretical valuation of European-style currency options. Also, they can be readily exploited by forex traders willing to engage in the increasingly popular pursuit of foreign exchange carry trades.

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Implementing Forex Carry Trades

Perhaps the simplest way for a forex trader to get into a carry trade would be to sell a lower interest rate currency and buy a higher interest rate currency forward for the desired time frame of the carry trade. Nevertheless, other ways of implementing carry trades exist for those willing to enter into transactions outside of the forex market. For example, such a carry trader might elect to borrow in the lower interest rate currency and then invest the proceeds of the loan in government-backed securities in a currency with a higher interest rate.

Carry Trade Example in AUD/JPY

Due to the exceptionally low interest rates seen in Japan during recent years as the country has struggled with low growth and deflationary pressures, the Japanese Yen has been involved in numerous foreign exchange carry trades as the short or borrowed currency.

On the other hand, Australia has enjoyed a period of relative economic strength compared to other major economies which has kept its interests rates relatively high and on a currently-increasing trend. These factors, along with Australia’s notable political stability and the added benefit the country receives from recent higher prices for its gold exports, have made the Australian Dollar a relatively safe and lucrative place to invest funds in carry trades.

Accordingly, a presently-attractive carry trade would involve borrowing Japanese Yen and lending Australian Dollars. A forex trader could implement a carry trade in this currency pair by buying AUD/JPY as a forward outright contract at a rate substantially below the current spot rate due to the substantial interest rate differential favoring the AUD.

The trader might then hold the position patiently, as it picked up value from the interest rate differential every day. Once the trader’s forward contract is two business days from delivery, if the AUD/JPY spot rate is not trading below the initial outright rate on the contract, the transaction will earn a profit for the trader.