When speaking about trading in Forex, the first strategy often comes to the mind is the practice of buying or selling a currency with the hope of benefiting from the price differential. But there is another popular strategy, and not just in Forex, called "carry trading", which tries to benefit from the difference between "interest rates" associated with different assets.
Generally, carry trading is the practice of buying a low-yielding asset and selling it to fund buying of a high-yielding asset. The low-yield usually associates with low-risk and low interest rate when the high-yield comes with high-risk and high interest rate.
It might look confusing but think about the way that banks make money. The most lucrative business of a bank is to give a low interest rate to short-term depositors and charge long-term borrowers higher rates of interest, pocketing the interest rates differential.
While carry trading could be practiced among different sorts of assets, currency carry trading in Forex might be the most straightforward one.
The higher-yielding currencies are those with higher interest rates while lower-yielding currencies are those with lower interest rates. Interest rate here refers to the benchmark interest rate set by the currency's central bank.
For example, in September 2008, benchmark interest rates in New Zealand and Japan were 7.5 and 0.5 percent respectively. Hence, the New Zealand Dollar (NZD) was a high-yielding currency while the Japanese Yen (JPY) was a low-yielding one.
Now consider an investor that borrows money from Japan and deposits the borrowed fund in New Zealand. She will receive 7.5 percent interest on her deposit while paying just 0.5 percent interest to the Japanese lender, pocketing the 7.0 percent differential.
Consider the previous example; our investor could lose money (even much more than the 7.0 percent she already receives) if at the same period the Yen starts to appreciate against the New Zealand Dollar.
Traders should also note that economies with higher-yielding currencies usually share some risky characteristics such as large current account deficit (relative to their GDP) or political instability.
In fact, such countries pay more interest on foreign investments to compensate that high level of risk. Currencies of such economies could easily come under speculative attack as soon as investors lose their confidence and start to unwind their investments.
The opposite is also true and you will pay interest when you sell a high-yielding currency in favor of a low-yielding one; in this example, selling NZD/JPY results in such a negative interest.
We say "almost" because Forex brokers have different rules regarding paying interest to their clients. In addition, almost all brokers charge interest for positions held overnight and that is why the swap – received or paid - can deviate, sometimes significantly, from the actual interest rates differential.