What is a Carry Trade?
A Carry Trade is a strategy built around interest rate differentials. In simple terms, it involves borrowing funds at a lower interest rate and reallocating that capital into another currency or asset that offers a higher return. The goal is straightforward: profit from the spread between borrowing costs and investment yields.
Rather than relying on short-term price movements, a Carry Trade focuses on returns that accumulate over time. As long as the interest rate gap remains favorable, the position can continue to generate income simply by being held.
Historically, the Carry Trade has been most commonly associated with foreign exchange and currency markets, where differences in national interest rates create clear opportunities. However, the concept is not limited to FX alone. The same logic can be applied to other asset classes, including equities, bonds, and even commodities, whenever a meaningful yield or rate differential exists.
At its core, every Carry Trade follows the same principle: borrow capital cheaply, deploy it into higher-yielding assets, and let the interest rate gap drive returns.
How Does a Carry Trade Work?
A Carry Trade typically works in a straightforward way. An investor borrows money in a currency with a very low or near-zero interest rate—the Japanese yen (JPY) is a classic example, as Japan has maintained low rates for many years. That borrowed capital is then converted into a currency with a higher interest rate, such as the U.S. dollar.
Once holding the higher-yielding currency, the investor can deploy it into assets that offer better returns, such as U.S. government bonds or other yield-generating investments.
For example, if you borrow Japanese yen at a 0% interest rate and invest the funds into an asset yielding 5.5%, your gross return—before fees and costs—would be 5.5%. In essence, a Carry Trade turns cheap capital into higher-return capital, as long as exchange rates do not move against you.
Why Do Investors Use Carry Trade Strategies?
Carry Trade strategies are popular because they offer a way to earn returns directly from interest rate differentials, without needing to wait for asset prices to rise. This makes them particularly attractive to hedge funds and institutional investors, who typically have the tools, experience, and risk controls needed to manage such positions.
Leverage is commonly used in Carry Trade strategies, meaning investors often borrow significantly more capital than they actually own. While leverage can substantially amplify returns, it also increases risk. If market conditions shift unexpectedly, losses can escalate just as quickly as gains.
Carry Trade Examples
One of the most well-known Carry Trade examples is the classic Japanese yen–U.S. dollar strategy. For many years, investors borrowed yen and invested the proceeds into higher-yielding U.S. assets. This approach worked well as long as the interest rate gap remained favorable and the yen did not strengthen sharply against the dollar. However, in July 2024, the yen experienced a notable appreciation, disrupting this long-standing trade.
Another common Carry Trade example involves emerging markets. In this case, investors borrow low-interest currencies and invest in higher-yielding emerging-market currencies or bonds. While potential returns can be attractive, these trades are highly sensitive to global market conditions and shifts in investor sentiment. When conditions turn unfavorable, profitable trades can quickly become problematic.
Risks of Carry Trade
Like any investment strategy, Carry Trade comes with significant risks. The most prominent is currency risk. If the currency you borrow strengthens sharply relative to the currency you invest in, your gains can be reduced—or even turn into losses—when converting back to the original currency.
For instance, if you borrow yen and invest in U.S. dollars, a stronger yen means you may receive fewer yen when closing the position. Interest rate changes present another risk. If the central bank of the funding currency raises rates, borrowing costs increase and reduce profitability. Conversely, if the central bank of the investment currency cuts rates, expected returns decline.
These risks became especially clear during the 2008 global financial crisis, when many Carry Trade positions—particularly those involving the yen—suffered heavy losses. More recently, changes in Japan’s monetary policy in 2024 strengthened the yen and triggered widespread Carry Trade unwinding, leading to market volatility.
The Impact of Market Conditions
Carry Trade strategies tend to perform best in calm, stable, and optimistic market environments. In such conditions, interest rates and currencies are relatively steady, and investors are more willing to take on risk.
However, during periods of volatility or economic uncertainty, Carry Trade strategies can quickly become dangerous. High leverage combined with rapid market moves may force investors to unwind positions, leading to sharp currency fluctuations and, in some cases, broader financial instability.
When the Bank of Japan unexpectedly raised interest rates in July 2024, the yen surged. Many investors rushed to close their yen-funded Carry Trade positions, selling risk assets to repay yen loans. This not only disrupted currency markets but also triggered broader sell-offs in high-risk assets worldwide, with leverage significantly amplifying the impact.
Carry Trade Summary
A Carry Trade is an investment strategy that seeks to profit from interest rate differentials between currencies or assets. While potentially attractive, it carries meaningful risks—especially in leveraged and volatile markets.
Successfully executing a Carry Trade requires a strong understanding of global markets, currency dynamics, and interest rate trends. Sudden policy shifts or unexpected market events can quickly reverse favorable conditions, making Carry Trade strategies better suited for experienced investors or institutions with sufficient resources to manage risk effectively.