The carry trade takes advantage of the difference in interest rates between currencies. It is a long-term strategy which involves going long on a currency with a higher interest rate and going short a currency with a lower interest rate. The higher interest rate currency is the invested currency, while the lower interest rate currency is the funding currency.
Let’s analysis a real case. Currently, the US interest rate set by the Federal Reserve is 2,5%, while the interest rate set by the European Central Bank is zero. The daily interest is calculated in the following way: (Interest Rate of the Currency that you are Long – Interest Rate of the Currency that you are Short) x Notional of Your Position
For 1 lot of USDEUR that has a notional of 100,000, we compute interest the following way:
(0.025 – 0.000) x 100,000 = approximately $6.8 a day
Carry trade is succesful when the currency pair either does to not change in value or appreciate. When interest rates decrease, traders are less compelled to go long the currency pair and are more likely to look elsewhere for more profitable opportunities.