Page 52 - Ultimate Guide to Currency Trading

carry trades, or making money selling short a low-interest currency (in this case, the USD) and using
the money to invest in a high-interest currency (in this case, the NZD). Additional information as to
actual entry and exit points of the NZD/USD trade would be given, and the report would be checked
out by a senior banker. That NZD/USD broker's report would then be sent out over the Internet to the
bank's customers and clients.

Interest Rates and FX Pairs

The most important factor in FX pair valuation is the interest rates of the two currencies. Before you
learn why that is true, you must realize that forecasting the change in the difference of interest rates
between two currencies is the key to trading successfully and profitably. Your estimates of the
direction of each element of a currency pair's interest rates will give you a bearing as to the best way
to trade that pair: long or short. If you think that a currency pair is going to have its interest rate widen,
then you would go long the currency that is increasing interest rates and sell the counter currency that
is staying the same or reducing rates.

A good carry trade can be profitable for years. Traders all over the world put more and
more bets in the carry-trade direction. It can seem too good to be true—until the point

ALERT when the carry trade gets stretched too far. It will then collapse with a vengeance,
crushing all long positions in its path!

Money is basically made with FX trading in two ways. The first is through capital gains; this is
the money made from buying low and selling high. The second method is through interest. With this
method, traders are entering in what is commonly called a carry trade. This carry trade is where a low-
yielding currency is used to fund a buy into a high-yielding currency.

The FX trader pays interest in the low-yielding borrowed currency (any-where from 0.25
percent to 0.05 percent annually) and can invest those funds at a higher rate (from 0.75 percent to
near 7.25 percent historically). This makes for a kind of money machine where money is churned out
through the interest rate differential. If you borrowed USD at 0.75 percent and used it to buy NZD at
7.25 percent, you would make 7.25 percent minus your borrowing cost of 0.75 percent for a yield of
6.5 percent. Not only that, but you would be making this investment at a leveraged amount, from 10:1
to 50:1. This means that at the high end of the leverage scale (50:1), you would make 325 percent
annual interest (6.50% x 50). Also, since most FX trading plat-forms offer continuous compounding,
you receive a daily payout of accumulated interest. This money can be added to your position for even
more compounding!

With this in mind, a well-thought out idea of where a currency pair's interest rates are heading
can give you the time advantage to get your trades in early enough to capture the inevitable
movement of a FX pair that is changing its interest rate differential. Your estimate can be
supplemented with the information that is obtained from your broker's website, brokers' reports, and
the word on the street. The word on the street refers to the thoughts that are being written and