There are numerous factors that drive currency value in Forex trading. Basically a currency goes up in value if the country exports more than it imports or if it receives investments in excess of its currency being used to invest elsewhere. The value of a currency goes up if it is in demand. A currency is in demand if investors buy the currency in order to make more money in that currency than they can with other currencies. A high interest rate encourages investment in a country and a low interest rate encourages taking out loans in the currency. The Yen carry trade is a case in point.
Japan has maintained rock bottom interest rates for most of the last twenty years since its stock market peaked. Individuals take advantage of the low rates by taking out loans in Yen, converting to another currency and then buying vehicles such as bonds or CD’s which bear a substantially higher rate of interest than the loan. This strategy works so long as the relative values of the Yen and the other currency remain roughly the same or if the “other” currency goes up in relation to the Yen. This has been known as the Yen carry trade. As the US maintains low interest rates and to the extent that the dollar continues to slide in value a dollar carry trade is also possible.
In Forex trading dollars or Yen versus other currencies in this instance it is important to be sure that the factors that drive currency value of the dollar or Yen do not change significantly. If the factors that drive currency value of the Yen, for example, change so that the Yen becomes more valuable then the person who engages in a Yen carry trade will be stuck with a less valuable currency in relation to the Yen and will lose money in the carry trade despite the difference in interest rates.
For many who have practiced the Yen carry trade the interest rate difference has been a bonus as the real reason for Forex trading in Yen and another currency is the expectation that the yen will fall in value. Taking out a loan in Yen and gaining interest in another currency is also a means of hedging your bets in Forex trading as the gain in interest in the carry trade will offset small losses in currency transactions.
Another of the factors that drive currency value is the use of a currency as a foreign reserve to back currency transactions and provide financial reserves. As most of the world’s foreign reserves are in dollars there is a steady need for the purchase of dollars by foreign banks. Thus one of the factors that drive currency value of the dollar is that other nations buy dollars to establish their own reserves. The US can print money and sell it without an immediate need to back up the currency with assets at home. A long term concern for the value of the dollar is what will happen if a basket of foreign currencies, with the dollar only a part, becomes the norm for foreign reserves. One of the factors that drive currency value of the dollar is that expectation, or fear.