Carry trade strategies on EURUSD

Carry trade is a useful long-term strategy that has its roots in the difference between sovereign interest rates. It is a strategy in which an investor sells a currency with a relatively low interest rate and uses the proceeds to buy another currency with a higher interest. As long as this strategy is studied, a trader is willing to make a profit of the difference in interest rates of the two countries. Let’s focus on the carry trade between the euro and the dollar. We suppose a trader borrows the euro at a cost close to 0.0%, converts to dollars and puts them on a deposit with an interest rate of 2.0%. This gives him a 2.0% profit each year, assuming the exchange rate remains unchanged. If a trader uses a leverage, the return on his capital could be even higher.
However, there is a great risk associated with this strategy. Using the example above, if the dollar weakens significantly against the euro (e.g. EURUSD increases), such exchange could lead to a loss despite a positive difference in interest rates. This is because one should pay more for the euro before repaying the loan amount. Moreover, due to the leverage effect, a small movement can lead to a huge loss. How can one reduce the risk related to a change in interest rates by central banks? A good tool which help traders forecasting the future levels of fed funds is the FedWatch developed by the Chicago Merchantile Exchange. The FedWatch, calculate the implicit probabilities related to each future FOMC meeting. As a consequence, a trader can always observe the investors’ beliefs on US cost of money and, at least according to the empirical evidence, implicit probabilities calculated on future contracts, are very reliable. He can do the same with the European Central bank, although a similar tools for the eurozone does not exist.
How is it possible to use the EURUSD carry trade to maximize trading proficts? The starting point in a carry trade strategy is a difference in interest rates between two currencies. In the forex market, it is hidden behind a swap. The swap arises due to overnight interest rates for each currency. Since currencies are always traded in pairs, a trader has always to borrow one currency to buy another, so a trader needs to pay interest on the loan, but also an interest on the currency he is dealing with. If the difference between what he pays and what he receives is positive, then he is entitled to a net swap credit. If the difference is negative, i.e. if he pays more interest than he receives, the account will be charged with the respective swap amount.