Understanding Carry trades

Let’s suppose I have some euros and if I deposit them at the bank for 1 year, they will give me a return of 3%. This is the nominal interest rate. What this means is, after 1 year I will get back 3% more euros than I put in. Yet if inflation is 1%, this means I can only buy 2% more stuff with those euros. I have only really gained a return of 2%. This is the real rate of interest. What if we expect the interest rate of EUR to increase to 4% in 6 months, but inflation stays about the same? If GBP stays the same, this means that the yield advantage between GBP and EUR will disappear after 6 months. That would likely cause the EUR/GBP exchange rate to rise because now I can only gain my 1% additional return for six months instead of one year

Currency trading is all about supply and demand supply and demand of money. A currency’s value against another currency increases because demand is greater than supply at a certain point. A currency’s exchange rate may rise and fall with interest rates, but the interest rates are rising and falling in response to changes in demand and supply and the driver of this is general economic conditions. When demands for capital are high as in a growing economy the real interest rates have to rise as well. Both corporate and government debt has to offer a high enough real return to be able to attract capital. Other