In this article we explain what a carry trade is, why it exists, how it works, what makes it profitable or risky, and the economic forces behind it.

The Carry Trade

A carry trade is a financial strategy in which a trader or institution borrows in a low-interest-rate currency (called the funding currency) and uses the borrowed money to buy assets denominated in a higher-interest-rate currency (the target currency). The goal is to profit from the interest-rate differential — known as the carry.

While the idea is simple, the strategy sits at the intersection of monetary policy, global capital flows, exchange-rate dynamics, and investor risk appetite.

1.The Core Idea

Interest rates vary from one country to another because central banks set them based on domestic economic conditions. For example:

Japan often has near-zero or even negative interest rates

Emerging markets like Brazil or Turkey often have much higher rates

This creates an opportunity:

Borrow where money is cheap, invest where money is expensive.

The difference in interest rates is the carry.

2.Step-by-Step Mechanics

Step 1 — Borrow in the low-rate currency

Example: Borrow 100 million Japanese yen (JPY) at 0%–0.25% interest.

Step 2 — Convert into the high-rate currency

Convert the yen into Australian dollars (AUD), South African rand (ZAR), or another currency with a higher yield.

Step 3 — Invest in a high-yield asset

Possibilities include:

Government bonds with higher yields

Bank deposits

Corporate bonds

Leveraged FX positions

For example, if AUD interest rates are 4%, the investor earns 4% on their AUD holdings while paying ~0% on the yen loan.

Step 4 — Collect the “carry”

If exchange rates do not move against the investor, the interest-rate spread becomes profit.

3.The Crucial Risk: Exchange Rates

A carry trade is not risk-free.

Because the strategy involves borrowing in one currency and owning another, the trader is exposed to exchange-rate risk.

If the high-interest-rate currency depreciates against the funding currency, the trader may lose more on the currency movement than they gain from the interest spread.

Example:

You invest in AUD (earning 4%)

But AUD falls 5% against JPY

You lose ~5% when converting back to yen

Result: a net loss even though the interest rate advantage was positive

This is why carry trades work only when exchange-rate volatility is low.

4.The “Carry Trade Unwind”

When global markets become fearful or unstable, carry trades unwind rapidly.

Why?

Investors rush back into “safe haven” currencies (like USD, JPY, CHF)

High-yield currencies suddenly fall

Traders must close positions to avoid losses

This accelerates the currency declines and causes huge volatility spikes

Carry trades are profitable during stability and dangerous during chaos.

5.Why Carry Trades Exist

Interest-rate differentials arise because:

Economies grow at different speeds

Inflation levels vary

Central banks follow different monetary policies

Some countries wish to stimulate growth (low rates)

Others aim to control inflation (higher rates)

These structural differences create persistent opportunities for carry.

Additionally:

Large institutional investors (hedge funds, asset managers) engage heavily in carry trades because they can apply leverage.

Some countries even become funding centres, e.g., Japan and Switzerland, because they maintain low rates for extended periods.

Lauren Hua is a private client adviser at Fairmont Equities.

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