# Currency Carry Trade: Definition As Trading Strategy and Example

## What Is a Currency Carry Trade?

A currency carry trade is a strategy in which traders borrow in a low-interest-rate currency and invest the proceeds in a high-interest-rate currency, aiming to profit from the interest rate differential. The strategy generally involves using [leverage](https://www.investopedia.com/terms/l/leverage.asp) to magnify any potential returns. 

The carry trade is one of the most popular [forex trading](https://www.investopedia.com/best-brokers-for-forex-trading-4587882) strategies, as it can be entered by simply finding and selling a low-yielding currency and buying a high-yielding one. Until recently, one of the most popular carry trades involved trading the low-yielding or even [negatively yielding](https://www.investopedia.com/articles/investing/070915/how-negative-interest-rates-work.asp) Japanese yen against currencies like the Australian dollar or the New Zealand dollar.

### Key Takeaways

*   A currency carry trade is a strategy that involves borrowing in a  low-yielding currency, investing in a high-yielding currency, and collecting the interest rate differential.
*   Traders using this strategy often rely on leverage to magnify potential gains.
*   The carry trade is one of the most popular trading strategies in the forex market.

## Understanding a Currency Carry Trade

The currency carry trade is one of the most popular [trading strategies](https://www.investopedia.com/terms/t/trading-strategy.asp) in the forex market. In a way, it is similar to the “buy low, sell high” motto. The first and main step in entering a carry trade is to determine which currency offers a high yield and which offers a lower one. 

For example, from the late 2000s to up until mid-2024, the Japanese yen was known for offering wide spreads against many global currencies, such as the [Australian dollar (AUD)](https://www.investopedia.com/articles/forex/11/aud-fx-traders-should-know.asp) and the [New Zealand dollar (NZD)](https://www.investopedia.com/terms/forex/n/nzd-new-zealand-dollar.asp).  

### Mechanics of the Carry Trade

In a carry trade, a trader [profits](https://www.investopedia.com/terms/p/profit.asp) from the difference in the interest rates of the two countries, as long as the [exchange rate](https://www.investopedia.com/terms/e/exchangerate.asp) between the currencies does not change significantly. Many professional traders use this trade because leverage allows them to magnify the potential gains.

If the trader in our example uses a common leverage factor of 10:1, the trader can potentially earn 10 times the interest rate difference. Considering that some [forex brokers](https://www.investopedia.com/best-brokers-for-forex-trading-4587882) offer leverage as high as 300:1, it’s not hard to see the appeal of carry trading. It’s equally easy to see how disastrous the outcome can be, if the trade goes against the trader.

The [funding currency](https://www.investopedia.com/terms/f/funding-currency.asp) is the currency exchanged in a carry trade transaction, typically characterized by a low interest rate. Investors borrow the funding currency and go short, while taking long positions in the asset currency, which has a higher interest rate. The central banks of funding currency countries such as the [Bank of Japan (BOJ)](https://www.investopedia.com/terms/b/bankofjapan.asp) and the U.S. [Federal Reserve](https://www.investopedia.com/terms/f/federalreservebank.asp) often engage in [aggressive monetary stimulus](https://www.investopedia.com/terms/e/economic-stimulus.asp) to prop up economic growth, resulting in low interest rates. As the rates drop, speculators borrow the money and hope to unwind their short positions before the rates increase. 

### When to Get in a Carry Trade, When to Get Out

The best time to get into a carry trade is when [central banks](https://www.investopedia.com/terms/c/centralbank.asp) are raising, or thinking about raising, [interest rates](https://www.investopedia.com/terms/i/interestrate.asp). People entering the carry trade will further help push up the value of the currency pair. Similarly, these trades work well during times of low [volatility](https://www.investopedia.com/terms/v/volatility.asp) since traders are willing to take on more risk. As long as the currency’s value doesn’t fall—even if it doesn’t move much, or at all—traders will still be able to get paid by collecting the interest rate differential. 

Conversely, a period of interest rate reduction won’t offer big rewards in carry trades. That shift in [monetary policy](https://www.investopedia.com/terms/m/monetarypolicy.asp) also means a shift in currency values. When rates are dropping, demand for the currency also tends to dwindle, and selling off the currency becomes difficult. For the currency trade to be profitable, there needs to be no movement or some degree of [appreciation](https://www.investopedia.com/terms/a/appreciation.asp). 

## Currency Carry Trade Example

As an example of a currency carry trade, assume that rates in Japan are 0.5 percent, and rates in the United States are 4%. If a trader borrows in the Japanese yen, and invests in the U.S. dollar, he can expect to collect the 3.5% spread.

The first step is to borrow yen and convert them into dollars. The second step is to invest those dollars into a security paying the U.S. rate. Assume the current exchange rate is 115 yen per dollar and the trader borrows 50 million yen. Once converted, he would have:

           U.S. dollars = 50 million yen ÷ 115 = $434,782.61

After a year invested at the 4 percent U.S. rate, the trader has:

           Ending balance = $434,782.61 × 1.04 = $452,173.91

Now, the trader still owes the 50 million yen [principal](https://www.investopedia.com/terms/p/principal.asp) plus 0.5 percent interest for a total of:

          Amount owed = 50 million yen × 1.005 = 50.25 million yen

If the exchange rate stays the same over the course of the year and ends at 115, the amount owed in U.S. dollars is:

         Amount owed = 50.25 million yen ÷ 115 = $436,956.52

The trader profits on the difference between the ending U.S. dollar balance and the amount owed, which is:

         Profit = $452,173.91 - $436,956.52 = $15,217.39

Notice that this profit is exactly the expected amount: $15,217.39 ÷ $434,782.62 = 3.5%

If the exchange rate moves against the yen, the trader would profit more. If the yen gets stronger, the trader will earn less than 3.5 percent or may even experience a loss.

## Risks and Limitations of Carry Trades

The main [risk of a carry trade](https://www.investopedia.com/articles/forex/09/japanese-yen-us-treasury-bonds.asp) is the uncertainty of exchange rates. Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, the trader runs the risk of losing money—this exact scenario played out in mid-2024, after the Bank of Japan raised its rate to levels not seen in over a decade, unwinding all the trades that involved borrowing in the yen. Also, as carry trades generally involve a lot of leverage, even a small movement in exchange rates can result in huge losses, unless the position is appropriately hedged.

An effective carry trade strategy does not simply involve going long a currency with the highest yield and shorting a currency with the lowest yield. While the current level of the interest rate is important, the future direction of interest rates is even more important. For example, the U.S. dollar could appreciate against the Australian dollar if the U.S. central bank raises interest rates at a time when the Australian central bank is finished tightening its rates.

Also, carry trades generally only work when the markets are complacent or optimistic. Uncertainty, concern, and fear can cause investors to [unwind](https://www.investopedia.com/terms/u/unwind.asp) their carry trades. The 45% [sell-off](https://www.investopedia.com/terms/s/sell-off.asp) in currency pairs such as the AUD/JPY and NZD/JPY in 2008 was triggered by the [subprime](https://www.investopedia.com/terms/s/subprime.asp) crisis that turned into the [global financial crisis](https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp). Since carry trades are often leveraged investments, the actual losses were probably much greater.

## Is Carry Trade a Popular Forex Trading Strategy?

Yes, it is one of the most popular forex trading strategies. Carry trade can be entered by simply finding and selling a low-yielding currency and buying a high-yielding one.

## How Does a Trader Profit From Carry Trade?

In a carry trade, a trader profits from the difference in two countries’ interest rates, as long as the exchange rate between the currencies does not change significantly. Carry trade is used by many professional traders because leverage allows them to magnify the potential gains.

## When Is the Best Time for Carry Trade?

The best time to get into a carry trade is when central banks are raising interest rates, or thinking about raising them. People entering the carry trade will further help push up the value of the currency pair.

## The Bottom Line

In a currency carry trade, traders borrow in a low-interest-rate currency and invest the proceeds in a high-interest-rate currency. The goal is to profit from the interest rate differential. The strategy generally involves using leverage to magnify any potential returns.  

_Correction—March 22, 2024:_ This article has been corrected to state that in a currency carry trade transaction, investors borrow the funding currency and go short while taking long positions in the asset currency.