Carry Trade: Easy Profits or a Risky Trap?

The carry trade can earn you a profit in forex by simply holding a position overnight, even if it goes sideways.

Sounds too good to be true? It isn’t. Making money in the forex market isn’t always about hitting the next big move on the chart. Sometimes it’s as simple as the difference in interest rates between two currencies.

However, the carry trade isn’t without flaws or risks, all of which I’ll cover in today’s guide. While strategies like the yen carry trade can generate steady returns, they can also wipe out gains in hours or minutes.

By the time you finish reading this blog post, you’ll know the meaning of a carry trade, how to take advantage of it, and the risks involved. If you’re a beginner, don’t worry. I’ll keep it simple and use real-world examples.

Let’s get started!

What Is a Carry Trade?

A carry trade is a strategy where you borrow money in a low-interest-rate currency and invest it in a higher-interest-rate one, profiting from the difference.

We’ll use the terms interest and yield to mean the same thing in this blog post. So, a low interest rate is synonymous with a low yield. The same goes for high interest and high yield.

So for a successful carry trade, you’d borrow a low-yield currency like the Japanese yen or Swiss franc to “invest” in a high-yield currency like the US dollar.

Think of it like borrowing money from your bank at a 5% interest rate, and then earning a 10% return elsewhere. That’s a no-brainer trade.

An example in the forex market is borrowing yen to invest in the USD. As long as the two rates remain about the same during the investment, you’ll make money. That’s a carry trade in a nutshell.

The JPY carry trade is especially popular because Japanese interest rates have historically been very low.

There was even a time in 2016 when the Bank of Japan lowered rates below zero, which is wild. Imagine your bank actually paying you to borrow money instead of the other way around.

Before we move on, let’s clarify a few key terms.

Funding Currency

The funding currency is the one with a low interest rate. We also call this a low-yield currency. It’s the one a trader sells (or borrows) for the carry trade strategy.

When buying a house, you want the cheapest funding possible. You’re borrowing funds from the bank to buy a home, just as you borrow a currency from your broker to buy one with a higher interest rate.

Target Currency

The target currency has the higher interest rate between the two. It’s also known as a high-yield currency, and it’s the one a trader buys during a carry trade.

In our house example, the target would be the home. You borrowed cheap (funding) from your bank to buy a home (target).

Interest Rate Differential

The differential is the difference between the interest rate of Currency A (funding) and that of Currency B (target). The difference between the two is what makes or breaks a carry trade.

For example, the Japanese yen carry trade has been popular for decades.

Why? Because of Japan’s ultra-low interest rates. Forex traders borrow yen at low rates to buy US dollars or Australian dollars and pocket the difference as a profit.

Other currencies with low interest rates, such as the Swiss franc or Chinese yuan, are also used as funding currencies in carry trades.

Carry trades are popular among hedge funds and institutional investors, but not so much with retail traders (you and me). They can get pretty complex, and the carry trade unwind can be brutal. More on that later.

To sum up, the interest rate differential between one lower-yielding currency and a higher-yielding one is what creates a profitable carry trade.

Let’s wrap up this section with our house-buying example. As long as the house appreciates faster than the interest rate from your bank, it’s a successful carry trade.

If it doesn’t, it becomes what’s called a negative carry, but more on that later.

Still with me? Let’s move on.

How a Carry Trade Works (Step-by-Step Guide)

Now that you know the basics, let’s jump into the step-by-step process for a successful carry trade.

Step 1: Borrow funds in a low-interest-rate currency like the yen

Don’t worry. You don’t need to fly to Japan to ask for a loan. In foreign exchange trading, the borrowing process starts when you open a trade through your broker.

For example, if you buy USDJPY, you’re borrowing the Japanese yen (quote currency) and buying the US dollar (base currency). Your broker handles everything in the background, so you never have to touch the currency or set foot in a bank.

In the trade above, the yen is the funding currency, and the dollar is the target currency. Japanese investors have used this approach for decades due to the Bank of Japan’s near-zero rates.

Step 2: Exchange It for a Higher-Yielding Currency

Exchanging yen for dollars is just as straightforward. In fact, there’s nothing you need to do to exchange one for the other.

When you buy USDJPY, your broker converts yen into dollars for you. That’s how you move from a low-interest-rate currency (the yen) to a higher-yielding one (the US dollar).

So, all you have to do is hit “buy” on USDJPY. That simple action allows you to borrow Japanese yen and exchange them for dollars. You’ve probably already participated in a positive carry trade without even knowing it.

Step 3: Invest in Bonds, Equities, or Hold the Position in the Forex Market

There are two options when deciding where to invest. The first is very straightforward, and the second involves more know-how to execute correctly.

Option one involves simply holding the position. In the USDJPY example, holding the buy (long) position is enough to qualify as a carry trade as long as the yen’s interest rate is lower than the dollar’s rate.

Option two involves borrowing the low-interest currency to invest in non-forex markets, such as US stocks and bonds. The idea is to invest in the highest-yielding market possible.

Most forex retail traders stick with option one. Simply holding USDJPY long is enough to benefit from a carry trade.

Option two is a favorite among hedge funds and institutional investors who have the knowledge and connections to pull it off. Borrowing yen to invest in US stocks or bonds requires international wires and a lot more legwork than simply holding USDJPY.

Step 4: Collect the Interest Rate Differentials Through Daily Rollover Payments

Now is the fun part: collecting the rate differential every 24 hours. Remember that the rate differential is the difference between a lower-yielding currency and a higher-yielding one.

The beautiful part about step four is that your broker handles this automatically. Every day at 5 pm EST, your broker calculates the interest rate differential between the two currencies you’re holding.

If you’re long USDJPY, you’ll usually get a positive rollover shortly after 5 pm EST. A profitable rollover is also called a positive carry. Of course, this assumes the yen has a lower interest rate than the USD.

If you’re short USDJPY, you’ll see a negative rollover, or negative carry.

For the forex retail trader, the difference between a positive or negative carry trade comes down to knowing each currency’s yield.

Get it right, and a position can earn you money on top of what a profitable trade would pay you. But get it wrong, and the negative carry will eat into your trade’s profits every 24 hours.

How to Choose the Right Currency Pair

You know how a carry trade works, but how exactly do you pick the right currency pair?

That’s where online tools like central bank interest rates and global interest rate tables come in handy.

With these tools, you can see the rates for each currency pair. They also show whether the interest rate is trending higher or lower.

Here are a few ideas as of this writing:

Low-Yield Funding Currencies

The Swiss franc and Japanese yen remain popular choices for funding currencies. The yen has been a go-to funding currency for decades, and I don’t see that changing anytime soon.

Other currencies are the Singapore dollar and the euro.

Just remember that rates change, so use the tools above before placing a trade.

High-Yield Target Currencies

Popular target currencies include the Australian dollar and the New Zealand dollar.

Riskier currencies like the Mexican peso, Brazilian real, South African rand, and Turkish lira have some of the highest interest rates.

But like everything, it’s a risk-reward balancing act. Less popular currencies like the rand and lira can offer higher yields, but they come with wider spreads and more uncertainty.

When Carry Trade Positions Work Best

Like any investment strategy, carry trades work best in certain conditions. The institutions that use this strategy look for relative stability when exchange rate movements are slow and steady.

There are two main ingredients here:

1. Wide interest rate differentials between two major currencies. Think about the yen and the US dollar we discussed earlier.
2. Calm financial markets where traders aren’t worried about a sudden plunge in asset prices.

When these conditions exist, risk management is easier, and traders are more likely to hold positions for the steady income. It becomes “easy money”, which is the dream scenario for every trader.

In calm environments like these, risk assets like stocks usually rally. That attracts traders and investors seeking the “bonus” yield that a carry trade offers. That’s why you’ll often see hedge funds running massive carry trade positions during long stretches of global stability.

Central banks are another huge component. In the USDJPY example above, you’re at the mercy of the Federal Reserve and Bank of Japan. As long as the banks maintain an accommodative policy, your carry trade lives on.

However, if a central bank even hints at a policy shift, watch out. The hedge funds that piled into the trade during market stability will sprint for the exit, leaving you with a loss if you aren’t careful.

That’s called an “unwind”, but more on that later.

To sum up, carry trades need wide rate differentials and market stability. As long as fund investments flow into foreign assets and the global economy is healthy, the carry trade lives.

And it’s not just an excellent tool for trading. You can even use it for portfolio diversification if you’re up for it.

What Makes It So Popular?

When you first got into trading forex, you probably weren’t focused on interest rate differentials. You may not have even known that each currency has its own interest rate.

For most traders, simply analyzing the chart and getting the direction right is enough.

However, the carry trade is like the cherry on top. You don’t necessarily need to stack interest rate differentials in your favor, but doing so makes a profitable trade even better.

The main benefit of a carry trade is a steady income from interest rate differentials. As long as the currency market and interest rates remain stable, you can earn a consistent profit from a positive carry.

The Japanese yen carry trade is a good example. As long as the Bank of Japan keeps rates near zero, the yen will continue to be an appealing funding currency for traders.

Why not try to profit from a positive rollover, especially if it’s a trade you’re already considering based on the chart?

Another benefit of carry trades is diversification. A carry trade may not always move in sync with stocks and bonds, and that’s a good thing. That helps hedge funds and institutional investors diversify their portfolios.

But for you and me, a positive carry is a bonus to an already profitable trade.

Why Carry Trades Unwind: Hidden Risks to Watch For

There are two main risks to any carry trade.

The first involves non-monetary market volatility. What is that? It’s the volatility that occurs outside of things like interest rate decisions. Examples include inflation numbers and employment figures.

These events can cause an otherwise profitable carry trade to turn against you.

The second risk category relates to sudden changes in a country’s monetary policy—for instance, a sudden change in the interest rate by a country’s central bank.

Changes in interest rates are by far the most significant risk to any carry, especially if it’s unexpected.

Carry Trade Volatility Risks

Let’s assume you buy USDJPY. The yen’s interest rate has remained low, and the US dollar’s yield is increasing.

A few days pass, and everything looks great. You’re receiving a positive carry payout at rollover every day, and the interest rate differential has attracted other buyers, which has helped to push USDJPY higher.

On the fourth day, you wake up to find your trade in the negative. US inflation numbers were well below forecast numbers, sending USDJPY tumbling.

Carry trades are a double-edged sword. The positive carry that made USDJPY so popular triggered more volatility than usual as traders raced for the exit.

Using leverage in carry trades makes matters worse. Sure, it can earn you a greater profit when things go right, but it can also amplify losses when things go wrong.

If the currency pair doesn’t move in your favor or at least stay sideways, the carry trade strategy won’t work. In other words, carry trades rely on market stability to be profitable.

That’s why I always say that a positive carry isn’t the trade, it’s simply the cherry on top.

Carry Trade Monetary Policy Risks

The second risk to holding a carry trade involves monetary policy changes by a country’s central bank.

If too many traders pile into a USDJPY long position, even the slightest change in policy from the Federal Reserve or the Bank of Japan can trigger a mass exodus.

Thousands of traders closing their long positions within seconds means your once profitable USDJPY carry trade is underwater.

When the yen appreciates rapidly due to such policy shifts, investors sell their carry trade positions to avoid further losses. It can quickly spill into global markets as well, affecting everything from stocks to bonds.

That’s a carry trade unwind in a nutshell. Traders also call this a liquidity cascade. It’s a domino effect where every closed position triggers more stop losses in a vicious cycle.

The sudden unwinding of carry trades during market shocks has contributed to several currency crises.

Retail traders mistakenly think their reaction time will save them.

Surely, a few seconds won’t make or break a trade.

But here’s the deal: Those hedge funds and other institutional players you’re up against use algorithms. These algorithms connect with multiple real-time data sources and react to news in nanoseconds.

So by the time you’ve taken your five seconds to see the news and close the trade, it’s too late. These algorithms have closed their positions, made thousands of calculations, and are on to the next opportunity.

Negative Carry (When the Trade Works Against You)

Nothing in trading is always sunshine and rainbows. Sometimes, you’ll find yourself on the wrong side of a rate differential in what’s called a negative carry.

It occurs when the funding currency’s yield exceeds that of the target currency.

Instead of collecting rollover as a profit, you’re paying it every day. It’s like taking out a bank loan for 10% and buying domestic bonds that pay 5%. Not a great investment strategy.

Negative carries can affect financial instruments and asset classes beyond forex. Many investors target stocks and bonds, and when they realize the trade is costing them, they’ll rush to exit.

That’s how a negative carry can trigger a broader sell-off in the financial markets.

An even more rapid unwinding can occur if there’s market stress or geopolitical risks. Any major shifts by a central bank can trigger a sell-off, impacting both stock prices and fixed income.

The bottom line is, don’t get greedy. A positive carry trade is a beautiful thing. However, there’s an inherent risk in it, especially if the trade becomes too crowded.

Currency Carry Trade Examples

The yen carry trade is arguably the most famous. In the 1990s and early 2000s, the yen had near-zero rates, making the yen an attractive funding currency.

The Japanese yen is a popular funding currency due to the Bank of Japan’s loose monetary policy. That includes periods of negative interest rates. Yes, negative.

Traders pay particular attention to funding currencies like the yen and Swiss franc when assessing carry trade opportunities.

However, the 2008 Great Financial Crisis changed everything. Market participants rushed into safe havens, and the yen spiked, wiping out carry trade profits overnight.

Another example is the Swiss franc carry trade. Switzerland had kept rates near zero, or even below, for years. That made the franc a popular funding currency, similar to the yen.

Traders borrowed francs to invest in higher-yielding currencies like the Australian dollar, New Zealand dollar, or even some emerging market currencies.

Some investors also target Latin America for higher returns from their carry trade strategies. It’s a much riskier path, but emerging markets can offer some of the highest yields if you nail the timing.

The 2015 Swiss National Bank shock ended years of easy money within minutes. Pull up a USDCHF chart with data back to 2015, and you’ll see what I mean. The pair plummeted nearly 2,000 pips in less than 24 hours.

Volatility is a carry trade’s nemesis. What seems like easy money today can turn into a nightmare if you aren’t careful.

Carry Trade vs. Arbitrage

It’s easy to confuse the two strategies, but they’re very different.

As you now know, a carry trade takes advantage of interest rate differentials. The lower rate of the funding currency allows a trader to profit from the higher interest rate of a currency at rollover.

Arbitrage, on the other hand, is when a trader takes advantage of a slight difference in a market’s price across multiple brokers.

Let’s assume EURUSD is trading at 1.1000 on Broker A and simultaneously trading at 1.1005 on Broker B. That’s a five pip price difference on the same currency pair.

If you’re an arbitrage trader, you would:

1. Buy euros at the cheaper price of 1.1000 on Broker A
2. Simultaneously sell euros at the higher price of 1.0005 on broker B

That’s an instant profit of 5 pips, and it’s risk-free because you’re buying low and selling high at the same time.

You can see how this is very different from a carry trade. One involves taking advantage of differences in interest rates, and the other takes advantage of slight price differences in the same asset across different brokers.

Going Beyond the Forex Market

We’ve mostly discussed the carry trade as it relates to the forex market. After all, this is a website aimed primarily at forex traders.

However, you can use the same principles you’ve learned here in other markets. There are versions of the carry trade for bonds, commodities, and even individual stocks.

Whenever there’s a difference in interest rates or yields, a carry trade can exist.

Carry trades can also have ripple effects across the global economy, influencing capital flows and market stability.

Additionally, differences in economic growth between countries can impact the success of carry trade strategies, as varying growth rates affect currency movements and asset returns.

But the risks we discussed above remain the same. As soon as conditions change, profits can disappear. And the longer the trade lasts, the quicker the profits tend to vanish once conditions change.

Final Thoughts

Borrow low, invest high is the name of the game with carry trades.

It sounds simple, but history shows that carry trade strategies like the yen and franc can unwind in a flash. Hedge funds and other institutions have the upper hand with their algorithms that make decisions in nanoseconds.

You also have to get the future direction of the chart correct. Any gains from a positive carry will be wiped out if you don’t.

As a retail trader, understanding interest rate differentials is like the cherry on top of a profitable trade. It’s a nice little bonus on top of the profits you’d already have from a winning trade.

But focusing all of your attention on finding positive carries is a mistake. Find A+ chart setups first, then narrow them down based on the difference in interest rates.

Frequently Asked Questions