What Is Carry Trade and How Does It Work in the Foreign Exchange Market?

A once-popular carry trade involved selling the Japanese Yen against the Australian or New Zealand dollar. The Bank of Japan maintained negative interest rates between 2016 and 2024, making the yen a great currency to borrow and fund high-yielding currencies like AUD and NZD. Investors partaking in that trade simply had to buy NZD/JPY or AUD/JPY through What Is the S&P 500 a forex broker.

The carry trade strategy is most popular in forex trading, where it involves buying a currency pair with high-interest rate spreads — the base currency has a high-interest rate. Given the risks involved, carry trades are appropriate only for investors with deep pockets and who “know what they are doing”. A carry trade strategy involves borrowing at a low interest rate from one currency and investing in an asset that provides a higher rate of return in another currency. The best time to get into a carry trade is when central banks are raising interest rates, or thinking about raising them. In a carry trade, a trader profits from the difference in two countries’ interest rates, as long as the exchange rate between the currencies does not change significantly.

What is the Carry Trade?

When you enter into a USDJPY trade, you are in effect, buying the US Dollar and selling the Japanese Yen, at a fixed contract size, and at the prevailing exchange rate. All of us, understand that when we buy the USDJPY, we want the price of USD to rise in relation to the JPY. But at a more structural level, essentially you are borrowing the Japanese Yen to finance your purchase of the US Dollar. In a positive carry trade, you will receive an initial net gain as you are paid interest for holding the position.

So, don’t just go into a currency trade because of interest rate differential.
Investors may also favor carry trades because they still earn interest revenue even if the currency pair doesn’t move.
Positive carries involve borrowing a currency with a low interest rate while buying a currency with a high interest rate.
While carry trading is often used within currency markets, it’s a trading style that’s also executed across commodities, fixed-income, and equity markets.
The phenomenon suggests that forward exchange rates are not neutral predictors of future spot rates.

What is the Yen Carry Trade? 💹

Typically in a carry trade, traders will borrow a currency with a low interest rate while at the same time, they will buy a currency with a high interest rate. As part of a currency carry trade, the currency which the trader is borrowing is known as the funding currency, and the currency they are buying is known as the carry currency. By borrowing one currency and buying another simultaneously, the trader will incur interest on their capital relative to the differential between the interest rates of the quote and base currency in a pair. The strategy can be—in fact, for many international traders, has been—highly profitable during periods of market calm and stable economic conditions. The allure of earning interest differentials makes carry trading a popular strategy, especially in environments where economic policies remain stable. However, the strategy demands diligence, strategic planning, and a readiness to adjust positions in response to market developments.

By doing this additional analysis, it may provide us with a stronger reason to enter into the position or it may give us a reason to pass on the trade altogether. The point is that there is much more to setting up a good carry trade candidate than simply looking at those pairs with the highest yields. The main benefit commodity trading strategy of currency carry trades is that, as well as potentially profiting from any differences in price between the two currencies in the pair, you are also accruing interest on your active position. You can see that if the dollar increased in value while the yen stayed the same, the profits would be even greater.

In any type of investing, diversification is usually the best hedge against adverse events that could cause substantial damage to your bottom line. Diversification across a basket of positions will typically provide a smoother equity curve and produce an optimal return to drawdown ratio. A swap agreement also referred to as a swap, is a sort of foreign exchange agreement between the counter parties. Usually the dealing bank will use the overnight Libor rate plus a certain spread to calculate the interest due.

Cons of currency carry trades

Hakan Samuelsson and Oddmund Groette are independent full-time traders and investors who together with their team manage this website. They have 20+ years of trading experience and share their insights here. There are plenty of factors affecting currency prices, but interest differentials and, subsequently, inflation rates have proven to be pretty reliable for the long term. However, the short-term fluctuations might be big and deviate from the purchasing parity theory (PPT).

This strategy fails instantly if the exchange rate devalues by more than the average annual yield. Many carry traders are perfectly happy if the currency doesn’t move one penny. The big hedge funds that have a lot of money at stake are perfectly happy if the currency doesn’t move because they’ll still earn the leveraged yield.

FX 101: Understanding carry trades in the forex market

While the interest rate differential is the main driver behind the carry trade, the exchange rate movement xtb.com reviews between the two currencies also plays a significant role. Even if the interest rate differential is favorable, a sudden adverse move in the exchange rate can offset the carry gains, leading to potential losses. Thus, traders must monitor both interest rates and currency trends closely to maximize their returns. In practice, yield-hungry investors are usually prepared to overlook poor fundamentals if the reward is high enough. The carry traders themselves then help to strengthen the high-interest-rate currency by investing in it. When that starts to happen, more investors want to get involved in the trade, helping the currency advance even more.

What Is the Theoretical Basis of Carry Trades?

This disrupted the forex markets, making yen-funded carry trades suddenly less profitable. Investors, now facing forex losses and higher interest on their JPY loans, scrambled to unwind their yen-funded carry trades. Carry trades can also be applied across different asset classes to diversify risks and avoid being overly concentrated in the forex markets.

Any changes in government policies, monetary regulations, or even economic crises can cause a major shakeup in exchange rates. Remember, carry trading can be a very popular strategy, but it’s not advised for beginning traders. It works best for those with high-risk tolerance who have the experience to manage the increased risk that leverage always brings. Carry traders borrow the funding currency, then take short positions in the asset currency. The difference in the interest rates will become the trader’s profit.

Let’s look at two separate examples for the two types of currency carry trading strategy – positive and negative.
You should consider whether you understand how CFDs and Spread Bets work and whether you can afford to take the high risk of losing your money.
By 2007, the Japanese yen carry trade had ballooned to an estimated $1 trillion, as investors capitalized on Japan’s near-zero interest rates to fund investments in higher-yielding assets globally.
They believe that exchange rates will either stay steady or not depreciate as much as the interest rate differential, allowing them to cash in on the interest rate spread.

Is a carry trade risk free?

In general, a carry trade is any strategy where an investor borrows capital at a lower interest rate to invest in assets with potentially higher returns. By using the currency markets, we can enter into a very similar transaction, and this technique is very popular among the biggest banks, hedge funds, and institutions. Nowadays, even small independent traders can enter into this type of trade. Essentially a currency carry trade can be done in the forex markets by borrowing a currency with a low interest rate and using that to finance the purchase of a higher yielding currency.

This is called carry trading—and it’s one of the most popular trading strategies in forex. It’s a straightforward strategy with the potential for high gains. But of course, this strategy is still susceptible to currency fluctuations after major news or world events, like the April Syrian missile strikes in Israel. You need to find and match the currencies with the highest and lowest yields.

Still, they could also be invested in other assets, such as stocks, commodities, bonds, or real estate, denominated in the second currency. This strategy became known as the yen-funded carry trade and is estimated to be as high as USD $4 trillion in total value 3. Carry traders will be paid while they wait as long as the underlying currency rates don’t fluctuate too far against them. When there’s a rapid unwinding, it’s those who panic first who panic best. They might get out in time before the market sinks into a “liquidity black hole.” Of course, the risk is if you flinch at the wrong time, losing gains or taking losses when a market turn doesn’t arrive. A Carry trade is carried out by receiving returns from holding one asset against borrowing another asset.