A strategy where a trader borrows in a low-interest-rate currency and invests in a higher-interest-rate currency to capture the interest rate differential. Carry trades profit from both the rate spread and potential currency appreciation.
How the Carry Trade Works
The carry trade involves selling (borrowing) a currency with a low interest rate and buying (investing in) a currency with a higher rate. The trader earns the Interest Rate Differential as a daily swap credit on the position. For example, if the Japanese Yen (JPY) has near-zero rates and the Australian Dollar (AUD) offers 4%, a long AUD/JPY position earns approximately 4% annually in swap income.
Risks and Rewards
Carry trades can be profitable over time because they earn income regardless of price direction, as long as the exchange rate does not move against the position by more than the interest earned. However, carry trades are vulnerable to sudden reversals when market sentiment shifts.
During Flight to Safety episodes, high-yielding currencies often depreciate sharply while Safe-Haven Currency currencies like the yen and Swiss Franc (CHF) appreciate. These unwinding events can erase months of accumulated carry profits in days. The 2008 financial crisis saw massive carry trade unwinds that caused extreme yen appreciation.
Popular Carry Pairs
Classic carry trade pairs involve the yen or Swiss Franc (CHF) as the funding currency against higher-yielding currencies like AUD, NZD, or emerging market currencies like the Mexican Peso (MXN) or Brazilian Real (BRL).
Related Terms
Interest Rate Differential
The difference in interest rates between two countries or currencies. Interest rate differentials are one of the primary drivers of exchange rate movements and form the basis of carry trade strategies.
Swap
The overnight interest charge or credit applied when holding a forex position past the daily cut-off time. Swap rates reflect the interest rate difference between the two currencies.
Rollover
The process of extending the settlement date of an open forex position to the next trading day. Rollover results in a swap charge or credit based on interest rate differentials.
Interest Rate
The cost of borrowing money, set by central banks as a primary monetary policy tool. Interest rate differentials between countries are the dominant driver of forex exchange rates.
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