2025-08-29
A carry trade is a forex trading strategy where a trader borrows money in a currency with a low interest rate and uses it to buy a currency offering a higher interest rate. The goal is to earn the interest rate difference—known as the carry—while also being exposed to movements in the exchange rate.
Carry trades are often used in calm, stable market conditions where interest rate policies are predictable.
Carry trades offer traders and investors a way to generate potential income from global interest rate differences, regardless of whether markets are rising or falling. They are most effective in “risk-on” environments—when investors feel confident and less cautious about volatility.
However, currency risk is always present. A shift in the exchange rate—or a sudden central bank move—can easily turn a profitable position into a losing one, particularly when leverage is involved.
Choose the Pair: Look for a high-yield currency (e.g. USD) to buy and a low-yield currency (e.g. JPY or CHF) to borrow.
Borrow the Low-Yielding Currency: Through your broker, you borrow or short the low-interest currency.
Buy the High-Yielding Currency: Use the borrowed funds to invest in the higher-interest currency.
Hold the Trade: As long as the interest rate difference remains favourable and the exchange rate is neutral or positive, you collect the carry.
Carry trades are mostly used in spot forex but also apply across futures and options markets.
Let's say you borrow the equivalent of $10,000 in Japanese yen at an interest rate of 0.5%. You convert that to US dollars and invest in a USD-denominated asset yielding 5% interest.
Interest Gained: $500 from USD investment
Interest Paid: $50 for borrowed yen
Potential Profit from Carry: $450
But here's the catch: if the US dollar weakens against the yen significantly, you'll lose when converting back—even if you earned the interest.
Assume you converted to USD when USD/JPY = 150
One year later, USD/JPY drops to 140
When converting back to yen, you receive fewer yen per dollar, which could severely reduce or even wipe out your gains
Best Conditions:
Stable or rising interest rate spreads
Minimal exchange rate volatility
Predictable central bank policies
General “risk-on” market sentiment
Worst Conditions:
High volatility or “risk-off” sentiment
Unexpected currency depreciation
Central bank rate reversals or interventions
Global financial crises or liquidity shocks
Some currency pairs are favoured for carry trades due to their rate differentials and relative liquidity:
Note: Emerging market currencies offer higher yields but come with political and liquidity risks that make them best suited to experienced traders.
Use stop-loss orders to protect against adverse currency moves
Avoid excessive leverage, especially across volatile pairs
Monitor interest rate announcements from central banks
Keep track of correlation between currencies and other markets (e.g. equities)
Scale in or out of positions rather than going all-in upfront
Know when to exit: carry trades can unwind fast if the market turns
Ignoring exchange rate risk: Many focus only on interest rates but forget that changing exchange rates often matter more.
Assuming carry profits are guaranteed: Even if the interest rate spread is positive, a currency decline can wipe out gains.
Using too much leverage: Because returns can feel slow, traders may use heavy leverage and get wiped out by small exchange rate moves.
Missing the market environment: Carry trades don't suit all market conditions. They're high risk during uncertain or fast-changing times.
Interest Rate Differential: The key driver of return in a carry trade—it's the gap between the lending and borrowing interest rates.
Currency Pair: Two currencies traded together; central to understanding and executing a carry strategy.
Leverage: Often used in carry trades but needs to be managed carefully due to amplified risk.
Exchange Rate Risk: The risk that exchange movements go against your position, potentially erasing returns from the interest rate spread.
Large institutions like hedge funds and investment banks actively use carry trading strategies. When carry trades are popular, they can:
Strengthen high-yielding currencies due to large inflows
Put pressure on low-yielding currencies, often used as funding sources
Cause fast reversals when there's a global risk-off event, as seen during the 2008 financial crisis and early COVID-19 periods
An unexpected risk event can cause mass exits from carry trades, known as a carry trade unwind, which often results in sharp currency moves—especially for emerging markets.
Carry trades can be a useful long-term strategy when market conditions are right. But they come with inherent risks, especially from currency fluctuations and central bank shifts. You need to watch two fronts: interest rates and exchange rates—and manage your exposure accordingly.
They're not set-it-and-forget-it strategies. Smart use of risk controls, position sizing, and market awareness turn a basic strategy into a professional one.
Disclaimer: This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by EBC or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.
