What is a carry trade and how does it work?

What does "carry trade" mean?

A carry trade is a popular strategy that capitalizes on differences in interest rates between two currencies or assets. One of the most widely used approaches involves borrowing funds in a low-interest-rate currency or asset and using those borrowed funds to invest in a higher-yielding currency or asset, aiming to profit from the interest rate differential.

For instance, an investor might borrow in a low-interest currency, such as the Japanese yen, which has historically maintained near-zero rates, and invest in a higher-yielding asset like the Australian dollar, or another currency offering a significantly higher return. In theory, the investor profits from the difference between the low borrowing cost and the higher yield generated by the asset. When trading spot FX with tastyfx, this refinancing credit is applied to positions in a currency pair held past 5pm EST each day.

While the carry trade is most commonly associated with the forex market, it can also be applied to other asset classes, such as bonds or commodities, where interest rate differentials provide similar opportunities. This strategy tends to be most effective when the interest rate gap is wide and stable and works best in low-volatility markets, where sharp fluctuations are less likely to undermine potential profits.

How does the carry trade strategy work?

The carry trade strategy revolves around borrowing funds in a currency or asset with a low interest rate and using those funds to invest in a higher-yielding currency or asset. Imagine an investor borrows in the Japanese yen currency, which has a low interest rate, and uses that borrowed money to purchase US dollars, which offers a higher interest rate. The goal is to earn a profit from the difference in the interest rates—the "carry." Over time, the investor earns interest on the US dollar they are holding, while only paying the lower interest rate on the borrowed Japanese yen, resulting in a steady stream of income from the interest rate differential. Trading spot FX makes this strategy simple, since taking a directional position in a currency pair means simultaneously buying one currency and selling the other – with the broker calculating the relevant overnight funding rates and passing the appropriate credit to customers with open positions in that market.

The expected outcome of this strategy is a consistent return from the interest rate spread between USD and JPY. This can work especially well in a stable market where interest rate differentials remain wide, allowing the investor to earn reliable income over time. However, there are potential risks. If the exchange rate moves against the direction of the position, the trade could turn unprofitable, as the drop in the value of their investment can quickly outweigh the positive carry earned. Additionally, changes in global interest rate policies can alter the balance of this strategy, narrowing the spread or even reversing it.

Carry trade example

One standout historical example of the carry trade involved the Swiss Franc (CHF), which was prominent in the early part of the 21st century. During this time, the Swiss National Bank (SNB) maintained very low interest rates, often below 1%, while other countries, especially those in emerging markets, had significantly higher rates. This created an opportunity for investors to borrow the low-yielding Swiss franc (CHF) and invest in assets or currencies that offered much higher returns, such as the Brazilian real (BRL) or South African rand (ZAR).

In practice, the carry trade worked by borrowing CHF at low interest rates and converting it into higher-yielding currencies like the Brazilian real, which at the time had interest rates around 15%. The investor would earn the difference in interest rates, profiting from the spread between the borrowing cost of the Swiss franc and the higher yield of the invested currency. This strategy was particularly attractive because of Switzerland's reputation for economic stability and the fact that the Swiss franc was historically seen as a "safe-haven" currency, making it relatively less risky for borrowing.

The expected outcome of this strategy was to earn a steady income from the interest rate differential. With low borrowing costs and relatively high returns from the Brazilian real or South African rand, the carry trade seemed like an easy way to profit from currency fluctuations while maintaining low risk exposure. However, as with any carry trade, the strategy relied on the exchange rates remaining stable. If the Swiss franc were to strengthen significantly against the Brazilian real or South African rand, investors would have to convert more of the local currency back into CHF, reducing or even eliminating profits.

The risks were realized in 2008, when the global financial crisis caused significant volatility in the forex markets. The Swiss franc began to appreciate as a safe-haven currency, especially against riskier emerging market currencies. This sharp appreciation led to heavy losses for carry traders who had borrowed heavily in Swiss francs and invested in higher-yielding, but riskier, assets. The carry trade in the Swiss franc highlights how a sudden shift in global risk sentiment—such as during a financial crisis—can quickly turn a profitable strategy into a significant loss.

What are the best carry trade currency pairs?

Some of the best currency pairs for carry trades are those that offer a significant interest rate differential between the two currencies involved. The Japanese yen (JPY) has long been one of the most popular funding currencies for carry trades due to Japan's historically low interest rates. The yen carry trade became particularly popular in the 2000s, as Japan maintained ultra-low rates, sometimes close to zero, while countries like Australia and New Zealand had much higher interest rates, making them ideal target currencies for carry traders. Investors would borrow in yen and invest in higher-yielding currencies, such as the Australian dollar (AUD) or the New Zealand dollar (NZD), capitalizing on the interest rate spread between them.

After the COVID-19 pandemic, the yen carry trade once again increased in popularity due to the low interest rate policy that was instituted to support the Japanese economy. This created another opportunity for traders to borrow in yen and invest in currencies with higher rates. The AUD/JPY and NZD/JPY remain two favored outlets for this trade, offering investors the opportunity to earn from the interest rate differential, provided they manage the associated risks.

Aside from the yen-based pairs, other popular carry trade currencies include the South African rand (ZAR), Brazilian real (BRL), and the Turkish lira (TRY). These currencies often offer higher interest rates compared to major currencies like the US dollar, making them attractive targets for carry traders looking for yield. For example, the ZAR/JPY or BRL/JPY pairs have been common in carry trades due to the higher rates in emerging market currencies like the rand and the real. However, these carry trades come with added risks due to the volatility and political instability that can affect emerging market currencies.

Overall, the most popular carry trade currency pairs tend to be those with a low-interest-rate currency (like the Japanese yen or Swiss franc) combined with a higher-yielding currency from a developed or emerging market (such as the Australian dollar, South African rand, or Brazilian real). However, while these pairs can at times offer attractive returns, it's important to be aware of the risks involved, such as currency fluctuations and other disruptions to the global markets.

For example, in 2024, the Bank of Japan (BOJ) surprised markets by raising interest rates and signaling a gradual tapering of its quantitative easing program. This change led to a sharp appreciation of the yen, causing many investors to unwind their carry trade positions. Between July and August 2024, the yen rose 14% against the U.S. dollar in less than a month, forcing many carry traders to liquidate their positions. This example highlights why carry traders need to monitor central bank policies and global economic conditions closely to assess the continuing viability of these strategies.

Advantages and disadvantages of the carry trade

One of the main advantages of the carry trade is the potential to generate consistent returns from the interest rate spread, especially when market conditions are favorable and the interest rate differential between the two currencies remains wide. This can be particularly appealing in low-volatility markets, where the risk of sudden currency swings is minimized, allowing investors to focus on earning a steady income from interest payments. For example, borrowing funds in a low-interest currency like the Japanese yen (JPY) and investing in a higher-yielding currency such as the Australian dollar (AUD) can offer reliable returns when the interest rate differential remains stable over time.

In addition to direct returns, the carry trade can potentially help diversify an investment or trading strategy. Since carry trades often involve currencies, they represent an alternative asset class that is not directly tied to equity or bond markets. For investors looking to diversify their portfolios by asset class, the carry trade can be a valuable tool for distributing capital across a broader range of assets, providing an additional layer of risk management.

However, the carry trade also comes with its share of disadvantages and risks. A major risk is currency risk, where unfavorable fluctuations in the exchange rate can erode profits or lead to losses. If the funding currency strengthens or the target currency weakens, the trade can quickly become unprofitable. For example, during the yen carry trade unwind in 2008 and again in 2024, when the Japanese yen unexpectedly appreciated against higher-yielding currencies like the Australian dollar, investors faced significant losses.

Similarly, changes in interest rates by central banks can alter the interest rate differential, affecting the viability of the carry trade. If the central bank of the target currency raises rates, the trade may become more profitable. But if the central bank of the funding currency increases its rates, it could negatively impact the profitability potential of the trade. Furthermore, during times of economic uncertainty or heightened market volatility, carry trades can become vulnerable, as exchange rates may shift rapidly, leading to unexpected—and sometimes outsized—losses.

Carry trade strategy key takeaways

• The carry trade strategy involves borrowing in a low-interest-rate currency and investing in a higher-yielding currency or asset, aiming to profit from the interest rate differential.
• The primary advantage of carry trading is the potential for consistent returns from the interest rate spread, especially in low-volatility markets where currency fluctuations are minimized.
• Carry trades can help provide portfolio diversification by offering exposure to currencies, an asset class not directly tied to traditional equity or bond markets, which can help manage risk and generate additional income.
• Currency risk is a significant disadvantage, as unfavorable fluctuations in exchange rates can reduce or eliminate profits, especially if the funding currency strengthens or the target currency weakens.
• Interest rate changes by central banks can impact the profitability of carry trades, making it crucial to monitor policy shifts and adjust strategies accordingly.
• Carry trades are most effective when the interest rate differential remains wide and stable; sudden shifts in market conditions, such as in times of economic uncertainty, can cause carry trades to unwind quickly.
• Popular carry trade currency pairs include those that involve low-yielding currencies like the Japanese yen (JPY) and high-yielding currencies such as the Australian dollar (AUD) or New Zealand dollar (NZD).
• While carry trades can provide steady returns, they come with risks, particularly when exchange rates or interest rate policies change unexpectedly.