The carry trade is a macro-driven strategy in foreign exchange where a trader borrows in a currency with a low interest rate (the funding currency) and uses those funds to buy a currency or asset that pays a higher interest rate (the target currency). The idea is simple: pocket the difference between what you pay to borrow and what you earn by holding the other currency or an interest‑bearing asset. In practice the trade also exposes you to exchange‑rate moves, so profit comes from both the interest differential (the “carry” or daily swap) and any favourable currency appreciation.
This article explains how a carry trade works step by step, shows a concrete example, describes common currency pairs and variations, and reviews the practical risks and risk‑management steps traders use. Trading carries risk; this is educational information, not personalized advice.
How a carry trade works — the mechanics
At its core a carry trade has three actions. First you borrow in the low‑yield currency. Second you convert the borrowed funds into the higher‑yielding currency. Third you invest or hold that position and collect the interest differential while you are exposed to changes in the exchange rate.
Imagine a simple, illustrative case. A trader notices a big gap between two central‑bank rates: the funding currency pays 0.5% per year and the target currency pays 4.5%. The trader borrows the funding currency, converts to the target currency, and places the proceeds in an interest‑bearing deposit or bond denominated in the target currency, or simply holds a long spot position that earns the broker’s daily rollover (swap) credit. The annual gross carry is roughly 4.0% (4.5% − 0.5%). If the exchange rate does not move, that interest gap is the trader’s gain (minus fees, margin costs and taxes).
Brokers and institutional traders usually implement the trade using spot positions with daily rollover (swap) adjustments, forwards or currency swaps. In retail trading the overnight swap shown in your platform reflects the interest differential, adjusted by the broker’s policy. Institutions can use forward contracts or other derivatives to hedge or leverage the position. Leverage is common because the daily interest flows on unleveraged positions are small relative to the capital employed; leverage magnifies both the carry income and the exposure to adverse currency moves.
A concrete numeric example
Suppose you borrow 10,000,000 units of a funding currency at 0.5% annually, convert them to the target currency at an exchange rate that gives you the equivalent of 90,000 units in the target currency, and invest at 4.5% for one year. Ignoring transaction costs and assuming no exchange‑rate change:
- Interest due on the loan: 10,000,000 × 0.5% = 50,000 (funding currency).
- Interest earned on the investment: 90,000 × 4.5% = 4,050 (target currency).
If the exchange rate stays the same, when you convert back to repay the loan your net gain equals the interest differential after currency conversion and any broker fees. But if the target currency weakens against the funding currency, that depreciation can wipe out the interest gain and cause a loss. If the target currency strengthens, you get both the carry and a favourable currency gain.
Funding currencies, target currencies and common pairs
Traders look for a stable, low‑rate funding currency and stable, higher‑rate target currencies that offer liquidity and manageable volatility. Historically, the landscape has shifted over time, but the pattern is familiar: low‑yield, safe currencies used to fund positions; higher‑yield, riskier currencies bought as targets.
Typical funding currencies (examples):
- Japanese yen (JPY)
- Swiss franc (CHF)
- Euro (EUR) during periods of easing
Typical target/high‑yield currencies or assets (examples):
- Australian dollar (AUD)
- New Zealand dollar (NZD)
- Emerging‑market currencies or higher‑yielding developed‑market assets
Popular carry pairs in calmer markets often include AUD/JPY and NZD/JPY because they combine higher local policy rates with historically low Japanese rates and good liquidity. But pair selection should always reflect up‑to‑date central‑bank settings and macro stability.
Carry principles also extend beyond spot FX: investors borrow at low short‑term rates to buy higher‑yielding bonds, dividend‑paying stocks, or even use stablecoins to fund staking in crypto markets. The same trade‑off — yield versus asset price (or currency) risk — applies.
When carry trades tend to work — the market environment
Carry trades generally perform best in “risk‑on” environments: low volatility, steady global growth, and stable or diverging central‑bank policies (one central bank on hold or easing while another maintains higher rates). In those conditions, investors accept currency‑risk and flows into higher‑yield assets push those currencies up or keep them stable, letting the interest differential compound into real returns.
Timing is important. Entering when the interest differential is wide and the market’s risk appetite is calm can produce steady gains. But those gains are often relatively small and accrue slowly, so traders use leverage or multiple positions to make the carry meaningful.
When carry trades break down — unwinds and shocks
Carry trades are vulnerable to sudden reversals when market sentiment shifts toward risk aversion. A common pattern in stressed markets is a sharp strengthening of traditional safe‑haven currencies and broad selling of higher‑yield currencies. That movement both reduces or reverses the interest advantage and creates currency losses when you convert back to repay funding loans. Rapid unwinds can be self‑reinforcing: as participants rush to close positions they push prices further, widen spreads, and increase the pain for remaining holders.
Events that can trigger unwinds include unexpected central‑bank moves, financial crises, sudden drops in risk assets, geopolitical shocks, or liquidity squeezes. Because many carry positions can be crowded, a single shock may lead to a large, fast market move.
Risks and caveats
Carry trading carries several layered risks that traders must understand before entering positions. Exchange‑rate risk is the most direct: currency moves can erase interest gains quickly. Leverage risk is also critical — leverage magnifies both gains and losses and can produce margin calls or forced liquidations. Interest‑rate risk matters: if the funding currency’s central bank tightens or the target currency’s bank cuts rates, the carry can shrink or flip. Liquidity risk can worsen losses in stressed markets as spreads widen and execution becomes costly. Finally, the crowding effect can amplify moves; many traders using similar strategies can produce a sharp, correlated unwind.
Managing these risks requires deliberate choices: moderate leverage, position sizing rules that respect margin requirements, stop‑losses or option hedges to limit downside, and ongoing monitoring of central‑bank signals and macro calendars. Because carry trades depend on macro conditions, they are not a substitute for a diversified plan, and they are not “set‑and‑forget.” Remember, past periods of steady carry income were sometimes followed by abrupt reversals; trading is inherently uncertain.
Practical considerations: execution, costs and hedging
Carry income shown on retail platforms appears as overnight “swap” or “rollover.” Brokers compute this daily based on interest differentials, their own financing costs and any markup. When you plan a carry trade, check how your broker calculates swaps, whether swaps are charged or credited on weekends, and how holidays affect the schedule.
Transaction costs, spreads, and borrowing fees reduce returns and should be included in any profitability calculation. Leverage amplifies those effects, so run worst‑case scenarios on currency moves and ensure your account has adequate margin buffers.
Hedging is another tool: some traders buy options to cap downside from sharp currency moves, or they use staggered positions and diversification across several currency pairs to reduce idiosyncratic risk. Hedging reduces upside as well as downside, so it’s a trade in itself.
A short guide to risk management for carry trades
Successful practitioners treat carry as a macro strategy, not a mechanical yield pickup. They blend position sizing discipline, stress testing, and awareness of correlation across markets. Maintain realistic expectations: daily swap credits are typically small relative to outright volatility, and carry strategies work best when combined with a robust plan that defines maximum drawdown, exit rules and margin management.
Finally, keep informed about central‑bank forward guidance and global risk indicators — a shift in policy or a rise in implied volatility is often the first warning sign that a carry trade has become more dangerous.
Key Takeaways
- Carry trade = borrow in a low‑rate currency and invest in a higher‑rate currency or asset to earn the interest differential, but you remain exposed to exchange‑rate movements.
- The strategy tends to work in low‑volatility, risk‑on environments and can produce steady but modest income; leverage amplifies both gains and losses.
- Major risks include currency moves, interest‑rate shifts, leverage/margin calls, liquidity shortages and crowded exits; active risk management is essential.
- Trading carries risk; this article is educational and not personalized trading advice — always test ideas in a demo and manage position size before trading live.
References
- https://www.investopedia.com/terms/c/currencycarrytrade.asp
- https://www.dukascopy.com/swiss/english/marketwatch/articles/forex-carry-trade/
- https://www.avatrade.com/education/market-terms/what-is-carry-trade
- https://www.ecb.europa.eu/press/financial-stability-publications/fsr/focus/2007/pdf/ecb~9ec60269c8.fsrbox200706_04.pdf
- https://www.jhinvestments.com/viewpoints/investing-basics/what-is-a-carry-trade-
- https://www.kellogg.northwestern.edu/faculty/rebelo/htm/carry.pdf
- https://www.chicagobooth.edu/review/carry-trading-not-just-for-currencies