Currency Carry Trades 101

The carry trade is one of the most popular trading strategies in the currency market. Putting on a carry trade involves nothing more than buying a high-yielding currency and funding it with a low-yielding currency. It’s similar to the adage, “Buy low, sell high.”

The Carry Trade

To enter a carry trade, a trader simply needs to buy a currency pair that represents being long a high yielding currency, and being short a low yielding currency. The first step in putting together a carry trade is finding out which currency offers a high yield and which offers a low yield.

The interest rates for most of the world’s liquid currencies are updated regularly on sites like FXStreet. You can mix and match the currencies with the highest and lowest yields.

Until recently, a popular carry trade involved selling the Japanese Yen against the Australian or New Zealand dollar. Between 2016 and 2024, the Bank of Japan maintained negative interest rates, making the yen a great currency to borrow and fund high-yielding currencies like AUD and NZD. Investors partaking in that trade simply needed to buy NZD/JPY or AUD/JPY through a forex broker. However, the trading opportunity unraveled in mid-2024 when Japan’s central bank raised its rate twice within a few months.

The Mechanics of Earning Interest

One of the cornerstones of the carry trade strategy is the ability to earn interest. The daily interest is calculated like this:

$\begin{aligned} &\text{Daily Interest} = \frac { \text{IR}_\text{Long Currency} – \text{IR}_\text{Short Currency} }{ 365 \text{ Days} } \times \text{NV} \\ &\textbf{where:} \\ &\text{IR} = \text{interest rate} \\ &\text{NV} = \text{notional value} \\ \end{aligned}$​Daily Interest=365 DaysIRLong Currency​−IRShort Currency​​×NVwhere:IR=interest rateNV=notional value​

Imagine the currency you’re long has an interest rate of 4.5%. The currency you’re short has an interest rate of 0.1%. Assuming a notional value of $100,000, you can compute interest as:

$\begin{aligned} &\frac { .0450 – 0.001 }{ 365 } \times \$100,000 \cong \$12 \text{ per day} \\ \end{aligned}$​365.0450−0.001​×$100,000≅$12 per day​

The amount won’t be exactly $12 because banks use an overnight interest rate that fluctuates on a daily basis.

Why Is This Strategy So Popular?

The returns on straight carry trades aren’t very large for most people but these trades are often executed with leverage. Even the use of five- to 10-times leverage can make that return extremely extravagant in a market where leverage runs as high as 200:1.

Investors may also favor carry trades because they still earn interest revenue even if the currency pair doesn’t move. While in practice currency rates constantly fluctuate, a carry trader would get paid the rate differential even if his chosen pair didn’t move a single pip. 

Low Volatility, Risk Friendly

Carry trades tend to perform well in low-volatility environments. Carry traders are looking for the yield. Any capital appreciation is just a bonus. Many carry traders are perfectly happy if the currency doesn’t move one penny. The big hedge funds that have a lot of money at stake are perfectly happy if the currency doesn’t move because they’ll still earn the leveraged yield.

Carry traders will get paid while they wait, as long as the underlying currency rates don’t fluctuate too far against them.

Central Banks and Interest Rates

Several factors are essential for a carry trade to work: wide interest rate differential, low volatility, stable interest rates, predictable monetary policies of countries involved, and a positive broad risk appetite. If any of these factors change rapidly, the results may be unpredictable.

The profitability of carry trades comes into question when the countries that offer high interest rates begin to cut them. The initial shift in monetary policy tends to represent a major shift in the trend for the currency. The currency pair must either not change in value or appreciate for a carry trade to succeed.

Foreign investors are less compelled to go long on the currency pair and are more likely to look elsewhere for more profitable opportunities when interest rates decrease. Demand for the currency pair wanes and it begins to sell off. This strategy fails instantly if the exchange rate devalues by more than the average annual yield.

Central Bank Risk

Carry trades will also fail if a central bank intervenes in the foreign exchange market to stop its currency from rising or to prevent it from falling further.

An excessively strong currency could take a big bite out of exports for countries that depend on them. An excessively weak currency could hurt the earnings of companies with foreign operations. The central banks of these countries could resort to verbal or physical intervention to stem the currency’s rise if, for example, the Australian Dollar or the New Zealand Dollar should get excessively strong. Any hint of intervention could reverse the gains in the carry trades.

If Only It Were This Easy!

An effective carry trade strategy doesn’t simply involve going long on a currency with the highest yield and shorting a currency with the lowest yield. The current level of the interest rate is important but the future direction of interest rates is even more important. 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 done tightening.

Uncertainty, concern, and fear can cause investors to unwind their carry trades.

When a Carry Trade Goes Wrong

Carry trade comes with many risks. As recent events show, it can take just one of its many moving parts to mishap for the entire trade to unravel.

Through the 2010s and into the 2020s, the Japanese Yen has been a go-to instrument for those trading carry. The country’s negative interest rates policy made it a great currency to borrow, while rising rates in many other developed economies made the potential carry trade only more compelling. For years the traders had exploited the rate differential between the Yen and its counterparts including the U.S. dollar, the Australian dollar, and the New Zealand dollar.

It all began to change in March of 2024, when the Bank of Japan raised its short-term policy rate to 0%-0.10%, ending nearly eight years of negative rates. Then, a few short months later, came a real shocker: on July 31st, 2024 the BoJ raised the rate again, to 0.25%, a level not seen since 2008. 

The Japanese yen jumped against the U.S. dollar. The already struggling USD/JPY pair plunged from around 155 to under 142 in a matter of days in a cascade of liquidations – traders closing their positions created additional pressure for the dollar, forcing even more traders to liquidate.

What may look like a relatively small change, a 0.25% rate adjustment in one central bank’s policy, ended up unwinding years of USD/JPY trading.

The Best Way to Trade Carry

An effective way to lower the risks of a carry trade is to diversify your portfolio. Create a basket of a few currencies that yield high, and a few that yield low. That way, a failure of one of the currency pairs involved will not result in a wipeout of your entire portfolio.

This is the preferred way of trading carry for investment banks and hedge funds. The strategy may be a bit tricky for individuals because trading a basket requires greater capital, but it can be accomplished with smaller lot sizes. The key with a basket is to dynamically change the portfolio allocations based on the interest rate curve and the monetary policies of the central banks.

Benefiting From the Carry Trade

The carry trade is a long-term strategy that’s far more suitable for investors than traders. Investors will be happy if they only have to check price quotes a few times a week rather than a few times a day. Carry traders, including the leading banks on Wall Street, will hold their positions for months if not years at a time. The cornerstone of the carry trade strategy is to get paid while you wait.

The Bottom Line

A carry trade is a popular forex strategy where traders attempt to take advantage of differences in interest rates between currencies. Although these differences may be small, carry trades are often executed with significant leverage in an effort to enhance profitability. While carry trades can work for prolonged periods, they may unwind abruptly if the underlying economic conditions change. Investors interested in carry trading need to study the mechanics of the trade, follow the economic trends of the underlying nations, and only enter a position once they’re confident they understand all the risks.