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The Australian dollar (AUD) is the official currency of the Commonwealth of Australia. It is also known as the Aussie, and this nickname includes both the AUD/USD and Australian dollar cross pairs.

The Australian dollar is the fifth most traded currency globally while AUD/USD is the fourth most traded currency pair according to the 2010 survey by the Bank for International Settlements.

A commodity play

Australia is the world’s second largest producer of gold after China and amongst the top six producers of copper. The country's exports are dominated by commodities and metals in particular. For this reason, the Australian dollar has traditionally been considered a commodity play, moving in the same direction as commodity and metal prices.

AUD carry trades

Australia emerged relatively unscathed from the Global Financial Crisis and offers some of the highest interest rates in the developed world. This had made it a popular choice for carry trades against lower interest rate currencies such as the Japanese yen, Swiss franc or US dollar. Interest rate differentials between Australia and other countries and the carry trades they nurture are one of the forces driving the Aussie.

How the AUD/USD carry trade works

In a carry trade, you sell the low interest rate currency, buy the high interest rate currency and make a profit from the interest rate differential.

To open on a carry trade, all you need to do is buy the AUD/USD currency pair. If the Australian dollar offers a 4.75% interest rate and the US dollar costs 0.25% overnight, you would instantly earn the 4.50% spread. This return assumes no leverage at all. You could increase the return on your investment by leveraging up.

If the Australian dollar were to appreciate, your return would increase further through lower US dollar interest payments over the term of the trade and capital appreciation when you close the trader.

However, carry trades can be brittle and returns volatile if currencies move against you. A fall in interest rates in the higher rate country or the prospect of a weakening currency can spark a reverse chain reaction, prompting investors to unwind their positions in successive waves. If the fall in the value of the currency is large enough, the capital loss could wipe out earlier returns.

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