What are interest rate differentials?
Interest rate differentials occur when you have two currencies with different interest rates for the underlying countries involved. In forex trading, currency quotes are always given in pairs. With each pair there is an associated interest rate differential. (more about how interest rates affect forex trading)
How to trade interest rate differentials
To trade an interest differential, the first thing you need to do is figure out exactly what the differential is on the pair you are interested in. Let's take for example the Australian Dollar(AUD) and the Yen(JPY). If the Australian Central Bank was paying 3 percent to the holders of Australian Dollars and the Japanese Central Bank was paying only 0.5 percent for holders of the Yen, the difference would be 2.5 percent, in favor of the Australian Dollar. That means, if you were to place a buy order on the AUD/JPY pair, you would be paid on that interest rate differential daily for as long as you held the pair. If you placed a sell on the same order, your broker would debit your account daily by the same amount since you would be an interest payer rather than receiver if you were selling that pair.
The advantage of trading interest rate differentials
The advantages of this type of trading are pretty obvious. By trading in the direction of positive interest, you would collect a premium payment every day. This would pad your bottom line profit over and over again. Not to mention, forex trading can be done with leverage, so your actual return on capital is amplified.
The dangers of trading interest rate differentials
The dangers of this type of trading are much more numerous than the advantages. First of all, the pairs that have high interest rate differentials are very sensitive to any signs of economic instability in the world. These pairs can become volatile with little warning. The volatility can easily wipe out any interest gains given. You must use prudent risk management or be prepared to hedge any downside risk.
Trading to collect positive interest rate differentials is called carry trading, and it's far from a new idea. While it seems like a given, trading interest rate differentials requires some experience in handling the unexpected and knowing when to get out. If you plan on trading interest differentials, be sure to observe history and see what can happen if you are on the wrong side of a trade without protection. The life you save may be your own.