Understanding Currency Carry Trade Strategy with Examples

A currency carry trade involves shopping for the lowest interest rates for borrowing, then putting those funds into higher-percentage assets in another currency.

These trades have traditionally been among the most popular ways professional and institutional traders make money in the foreign exchange (forex) market. The strategy is straightforward: borrow money in a country where interest rates are low, like Japan (where for decades going into the mid-2020s, rates had been near zero), and invest that money in a country where rates are higher, like Australia, New Zealand, or the U.S. The difference between these rates is where traders profit.

Below, we take you through the strategy, how it works, and when it doesn't—the last is a critical point to review given that many traders have lost their footing as the structure of these markets has changed in recent years.

What Is Currency Carry Trading?

The currency carry trade is one of the most popular trading strategies in the forex market. While most think of currency trades as an attempt to break even—you're hoping to get as near as possible to the value of your home currency when at an exchange booth abroad—it's an attempt to apply the “buy low, sell high” motto and profit from these lateral trades.

But how? In currency carry trading, when interest rates in a country decrease, speculators often take advantage of the lower cost of borrowing in that nation's currency—called the "funding currency." They borrow at the reduced interest rate to fund investments in higher-yielding currencies or assets. The goal is to "carry" the interest rate differential as profit.

For example, from the late 2000s to 2024, the Japanese yen (JPY) was known for offering a significant difference in interest rates against important global currencies, such as the Australian dollar (AUD) and the New Zealand dollar (NZD). The trade was so robust and seemed to come off with such relative ease, given the stability of Japan's low rates, that many in the financial media came to call it "a cost-free source of profit."

But that wasn't and isn't true since these trades come with significant risks and, thus, substantial costs should the economics shift in the wrong direction for you. As in the rest of finance, if there were a cost-free way to profit, word would have gotten around—and you wouldn't have that "cost-free" profit very long.

That's because, unlike simply moving money among local banks, carry trades have an extra layer of complexity, meaning more risk. When dealing with different currencies, their values can change against each other, potentially wiping out any profits from the interest rate difference. It's like trying to catch two moving targets at once: you need both the interest and exchange rates to work in your favor.

Until 2024, borrowing in JPY to invest in higher-yielding currencies was so popular that it made up about one-fifth of daily currency trading—and one can understand why it was depicted as a relatively easy trade. But when the Bank of Japan suddenly raised rates to levels not seen in over a decade—rates, by the way, that was still a tenth or less than in the U.S. and other major central economies—it caused a market earthquake that revealed just how risky these seemingly safe trades can be.

How the Carry Trade Works

The carry trade is like a global version of arbitrage between savings accounts but with much higher stakes. How does it work? Let's say you notice Japanese banks are offering loans at 0.5% interest while U.S. bonds are paying 4%. Professional traders might borrow significant amounts of yen (it has to be enough so the interest rate differential can make up for administrative costs and the risks involved), convert it to dollars, and invest in those higher-yielding U.S. bonds.

As long as exchange rates stay stable, traders earn the difference between the two interest rates—in this case, about 3.5%. However, most professionals don't actually exchange physical currency. Instead, they use currency futures or forward currency markets, where they can borrow money (i.e., use leverage) to magnify their returns. This leverage is why carry trades can be so profitable—and so disastrous—your potential losses are also magnified.

It's like putting a small down payment on a house but getting returns on the full value. When things go well, you make money on money you never had. If things go badly, you can lose far more than your initial investment. Considering that some forex brokers offer leverage as high as 300 to one (that is, loans as high as 300 times the value for the underlying asset), it’s not hard to see the appeal of carry trading. It should be equally easy to see how disastrous the outcome can be once the underlying dynamics (interest and currency exchange rates) swing against you.

That's why traders must ensure they're always ready to unwind their short positions—repay the borrowed currency—before interest rates increase, as rising rates could make holding or repaying these positions far more costly.

The Most Popular Carry Trades

Carry trades thrive on the difference in interest rates between countries, and while USD/JPY is one of the most well-known pairs, several others have been popular:

Australian Dollar (AUD)/JPY

The Australian dollar typically offers higher interest rates because of its commodities-driven economy, while Japan's rates are historically low. This pair is favored during stable global growth and strong demand for raw materials.

New Zealand Dollar (NZD)/JPY

Like the Australian dollar, the New Zealand dollar often has higher interest rates, making this another attractive pair for carry traders, especially during periods when agricultural exports are up the markets have low volatility.

USD/Swiss Franc (CHF)

The Swiss franc's traditionally low rates, driven by its role as a safe-haven currency, contrast with the relatively higher rates in the US, creating opportunities for carry trades.

Euro/Turkish Lira (TRY)

This trade exploits the higher interest rates in Turkey compared with the eurozone. However, it's riskier because of Turkey's economic volatility and political instability.

Timing Your Entry and Exit in Currency Carry Trades

The best time to start a carry trade is when central banks are raising interest rates or signaling they might do so. For example, if the U.S. Federal Reserve is hiking rates while Japan keeps rates low, more traders will borrow in yen to buy dollar assets. As more people make this trade, it tends to push up the value of the dollar against the yen, creating even more profits for early movers.

However, experienced traders watch for several warning signs that it's time to exit:

• When central banks in low-interest-rate countries hint they might raise rates
• During periods of global market stress, when investors typically rush to "safe haven" currencies like the U.S. dollar
• When too many other traders are making the same bet, this can lead to a rapid unwinding if sentiment changes
• If economic data or political events suggest instability in either country

The 2024 Japanese yen episode offers an unfortunate example. When the Bank of Japan unexpectedly raised rates, traders who had borrowed in yen faced a double hit: they had to pay higher interest on their loans and watched the yen strengthen against other currencies, making their debts more expensive to repay.

Real-World Example of a Currency Carry Trade

Let's walk through an example of how a carry trade works. Suppose Japanese interest rates are at about 0.5% and U.S. rates are at 4%. A trader borrows 50 million yen (about $434.8k at an exchange rate of 115 yen per dollar).

After converting to dollars and investing at the U.S. rate of 4% for a year, the trader would have $452,174. Meanwhile, they'd owe 50.25 million yen in Japan (the original 50 million plus 0.5% interest). If the exchange rate stayed at 115 yen per dollar, that debt would equal about $437k.

The difference—about $15,217—is the trader's profit, representing the 3.5% spread between U.S. and Japanese rates. However, here's the catch: If the yen strengthens against the dollar, these profits can quickly evaporate. This is exactly what happened in 2024 when Japan raised rates, causing the yen to surge and wiping out many traders' gains.

Historical Example of the JPY/USD Carry Trade

The data on overnight rates for the Bank of Japan and the U.S. Federal Reserve shows a significant shift that brought about considerable trouble for major players in the carry trade market in August 2024. Let's review what happened with a simplified timeline of events:

2023: A Long and Stable Period Continues

• The Bank of Japan kept its overnight rates negative (e.g., -0.064% in August 2023), while the U.S. dollar (USD) had high rates around 5.33%.
• This interest rate differential made the JPY/USD carry trade highly attractive. Traders could borrow yen at a low cost (that's what the low or even negative interest rates for the JPY were meant to do) and invest in dollar-denominated assets for strong yields (not necessarily the intended result—central banks are generally not focused on spurring investments in other currencies).
• The trade was profitable and remained stable through late 2023 as the yen's rates remained negative and the dollar rates held steady.

Early 2024: Warning Signs

• Starting in March 2024, Japan's rates turned positive (0.022%), signaling a policy shift by the Bank of Japan to tighten monetary policy. The central bank's move was seen as responding to inflationary pressures worldwide, including in Japan, and the desire of many within the Japanese financial community to finally normalize monetary conditions.
• Despite this shift, US rates remained high at 5.33%, keeping the carry trade moderately attractive, though the profit margin narrowed slightly.
• Hedge funds and other leveraged players took advantage of the interest rate differential, borrowing in yen and investing in USD-denominated assets, further inflating risks.

Market Shocks in August 2024

• The carry trade unraveled when Japan's rising rates, coupled with heightened market volatility, created significant challenges for investors who had leveraged (or borrowed to increase) the amount of their trades.
• A later U.S. Federal Reserve report placed much of the blame on hedge funds for the crisis.

1. First, they inflated the risks in the market by becoming heavily leveraged (they were borrowing a lot).
2. Then, while liquidity dropped in early August 2024 (with the big players trying to sell at the same time in early August, it became really hard to buy or sell enough Treasury bonds and other low-risk investments without causing big price swings), they rapidly sold off their positions simply for internal reasons (to adhere to their internal volatility metrics, not because they were running out of money or facing margin calls).

• In short, the Federal Reserve claimed, they helped spark the crisis, then instigated a stampede out the door, not to avoid a fire, but just to meet internal metrics. This might be all well and good if the effects were limited to a few heavy hitters in the forex community, but it wasn't.

Post-August 2024: Continued Unwinding

• As 2024 continued, USD rates began to decline (e.g., 4.83% by October and 4.64% by November) and concerns over geopolitical tensions and the U.S. debt burden rose, the JPY/USD carry trade became even less attractive. This led to even more unwinding in the carry trade, though more gradually than in August.

Understanding Risks and Limitations in Currency Carry Trades

While carry trades can look like easy money in calm markets, they come with several major risks:

• Exchange rate risk: The biggest danger comes from currency value changes. For example, when Japan raised rates in 2024, the strengthening yen meant traders needed more dollars to pay back their loans denominated in yen, sometimes wiping out years of profits in days.
• Interest rate shifts: Central bank decisions can quickly change the game. The Bank of Japan's 2024 rate hike shows how policy changes can trigger a mass exodus from carry trades, creating a snowball effect as traders rush to unwind positions.
• Market sentiment: When investors get nervous about global risks, they often flock to "safe haven" currencies like the yen.
• Algorithmic trading: Market sentiment is no longer just vibes about the market's mood but can be derived the various metrics (some even black-boxed or hidden from their system owners in AI systems) used by internal systems for the major funds and institutional investors, as occurred with hedge funds in August 2024.
• Leverage risk: Most carry traders use borrowed money to amplify their returns. While this can multiply profits when times are good, it also magnifies losses when markets turn. A small move in exchange rates can trigger margin calls, forcing traders to close positions at the worst possible time.
  

The Bottom Line

Currency carry trades—borrowing in a low-interest currency to invest in a higher-yielding one—can seem deceptively simple and profitable, especially during calm market periods. However, as the 2024 Japanese yen episode demonstrated, these trades can quickly unwind when market conditions change. Carry trades work best in stable conditions but can rapidly deteriorate when multiple risks converge, particularly for traders using leverage to increase potential returns.

While professional and institutional traders can profit from interest rate differences between countries, the strategy involves significant risks from exchange rate shifts, sudden interest rate changes, and market sentiment swings.