Carry trade is a strategy where traders borrow money in a currency with a low interest rate and invest it in a currency with a higher interest rate, profiting from the difference. This works because forex traders can hold currency positions for extended periods and earn daily interest, called "carry," on the position.
How Carry Trade Works
To execute a carry trade, a trader selects two currencies where one has significantly higher interest rates than the other. For example, if Japanese yen rates are 0.1% and Australian dollar rates are 4%, borrowing yen to buy AUD lets the trader earn approximately 3.9% annually, paid daily as roll-over interest.
The trader holds the position open as long as the interest spread remains profitable and market conditions don't turn adverse. Many traders use carry trades as a long-term passive income strategy, letting their account accumulate interest without active trading.
Risks of Carry Trade
While the daily interest gains are predictable, carry trades expose traders to sharp currency fluctuations. If the currency you've invested in weakens significantly against the currency you borrowed, the loss on the exchange rate can wipe out months of interest gains. Central bank interest rate changes, economic crises, or sudden market sentiment shifts can trigger rapid currency movements that end unprofitable carry positions.
Carry trades are particularly vulnerable during market stress, when liquidity dries up and traders rush to close positions simultaneously, pushing exchange rates sharply against them.
Carry Trade Strategy Considerations
Traders use carry trades to complement other strategies, typically focusing on stable currency pairs and monitoring central bank policies for interest rate signals. The strategy works best in calm, range-bound markets where currency values move predictably.
