Carry Trade
What is Carry Trade?
A carry trade borrows in a low interest rate currency and invests in a higher-yielding one, earning the interest gap if the exchange rate holds.
The trade works because interest rates differ across currencies while exchange rates do not always move to offset the gap. Uncovered interest parity predicts that the high yield currency will depreciate by exactly the interest differential, leaving no expected profit, but over short horizons in many samples that currency held its value or even strengthened, which is why the strategy persists. Returns tend to arrive in small steady increments and vanish in sudden bursts, because carry positions are leveraged and unwind together when volatility spikes, driving the funding currency sharply higher. Hedging the currency leg with a forward contract removes the risk and the profit at the same time, since covered interest parity means the forward price already contains the interest gap.
Carry Trade: a worked example
Borrow 10,000,000 yen for one year at 0.5 percent when the spot rate is 100 yen per dollar. Selling the yen gives $100,000, which goes into a one year dollar deposit paying 5.5 percent and matures at $105,500. The yen loan comes due at 10,000,000 times 1.005, or 10,050,000 yen. If the rate is still 100 yen per dollar, repaying costs $100,500 and the profit is $5,000, the 5 percentage point interest gap applied to the position. Now let the yen strengthen to 90 per dollar: repayment costs 10,050,000 divided by 90, or $111,666.67, so the position loses $6,166.67 even though it won on interest. Break even sits at 10,050,000 divided by 105,500, which is 95.26 yen per dollar, so a yen appreciation of only about 5 percent erases the entire carry.
The mistake students make with carry trade
Students call the carry trade arbitrage, because the interest differential looks like a locked in spread. It is not arbitrage: nothing is guaranteed, and the position is an unhedged bet that the exchange rate will not move against you by more than the interest gap. Hedge it by buying the funding currency forward and covered interest parity bites, because the forward price already embeds the differential, so the expected profit shrinks to almost nothing. The related slip is quoting the interest gap as the return, when the actual return is that gap plus whatever the target currency does against the funding currency.
Carry Trade questions
How does a carry trade make money?
A carry trade makes money by borrowing where interest rates are low and investing where they are higher, keeping the difference as long as the exchange rate does not move against the position. Borrowing at 0.5 percent and depositing at 5.5 percent earns 5 percent a year on the amount involved. That gain survives only if the high yield currency holds its value, since it disappears once that currency falls by roughly the size of the interest gap and turns into a loss beyond that point.
Why does uncovered interest parity not kill the carry trade?
Uncovered interest parity says the high interest currency should depreciate by exactly the interest differential, which would leave a carry trade with zero expected profit. In practice, over short horizons and across many samples, high interest currencies did not depreciate that much and sometimes appreciated, leaving average carry returns positive. One explanation is that the return is payment for crash risk: the strategy delivers small regular gains and occasional very large losses, so the average compensates for a tail that ordinary volatility measures understate.
What are the risks of a carry trade?
Currency risk dominates, because the funding currency can strengthen and repaying the loan then costs more than the interest earned. Leverage magnifies that, since carry positions are usually built on borrowed money, so a modest exchange rate move can wipe out the equity behind the trade. Crowding adds a third layer: many investors hold the same positions, and when volatility rises they exit at once, pushing the funding currency up and deepening losses for everyone still holding.
Formula / Example
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