Carry trade

A carry trade borrows funds in a currency with a low interest rate and invests the proceeds in assets denominated in a currency with a higher interest rate, aiming to capture the difference, the "carry", between the two. A classic example is funding in a low-yield currency like the Japanese yen and investing in higher-yielding currencies or bonds elsewhere.

The trade's return combines the interest rate differential with the change in the exchange rate over the holding period; the interest gap is captured only if the funding currency does not appreciate by more than that gap. This link between interest rates and expected currency moves is the same relationship tested by purchasing power parity and priced into forward points in the FX forward market.

Carry trades are a core strategy in FX and macro trading and are watched as a market-wide risk indicator: when volatility spikes, carry trades tend to unwind quickly as investors close borrowed positions, which itself can drive sharp moves in the funding currency. The main pitfall is treating the carry as a low-risk yield pickup — it is compensation for currency and liquidity risk that can reverse abruptly, and losses in a rapid unwind can exceed months or years of accumulated carry.