Carry trade: definition

Collecting the rate gap

The principle is simple: you borrow in a currency where rates are low, the funding currency, and invest in a currency where they are high. As long as the exchange rate doesn't move, you collect the yield difference. In the currency market, this means buying the pair whose base currency pays more: buying AUD/JPY was the textbook example when Japanese rates were zero.

For a retail trader trading spot, this return shows up in the rollover swap credited or debited each night the position stays open.

The risk: the unwind

The carry trade earns a little regularly and loses a lot at once. When risk appetite turns, everyone who borrowed the same funding currency buys it back at the same time to repay, which sends it soaring. Currency losses then wipe out months of rate differential.

In August 2024, a Bank of Japan rate hike followed by a disappointing US employment report triggered a brutal unwind of yen-funded positions, and a marked fall in pairs such as USD/JPY within a few days.

When it works

The carry trade thrives when volatility is low and central banks are predictable. Traders therefore watch implied volatility and fund positioning in the funding currency: a market that is already heavily committed is more exposed to a stampede.

Frequently asked questions

Which currencies are used for the carry trade?

Funding currencies are low-rate ones, historically the yen and the Swiss franc. Target currencies are high-rate ones, often emerging-market or commodity-exporter currencies.

Is the carry trade risk-free?

No. The gain depends on a stable exchange rate, and a contrary move of a few percent is enough to wipe out a year of rate differential, even more so with leverage.