A carry trade is an investment strategy where investors borrow money in a currency with a low interest rate (e.g., Japanese yen) and use the proceeds to invest in an asset or currency with higher yields (e.g., US dollars). Profits come from the difference between the two interest rates (the “carry”) and it generates strong returns when the interest rate differential is wide and the exchange rate remains stable. However, when the volatility rises or central banks shift policies, the carry trade can quickly fall apart.
Investors take out a loan in a funding currency where interest rates remain low (e.g., Japanese yen, Swiss franc) and then exchange the borrowed money into a target currency or buy assets (foreign government bonds, high-interest deposits, emerging market debts or equities) denominated in it, offering higher yields. If the higher interest rate investors earn is 5% and they pay 0.5% on the loan, investors’ gross annual return will be 4.5% before reflecting any changes in exchange rate. At the end, the investment will be sold and the proceeds will be converted back into the original funding currency to repay the loan. The net gain or loss will also depend on the exchange rate movement during the holding period.
For the carry to be profitable, several conditions need to be met. Carry trade can be most profitable in periods of wide interest rate differentials, low volatility and in a stable currency market. They can be risky during policy shifts or under global financial crises.
Large and stable interest rate differentials (positive carry): Carry trade will be profitable when central banks (e.g., US,
Australia) in one country maintain higher interest rates while central banks (e.g., Japan, Switzerland) in another country keep their interest rates low. For example, Dollar-yen carry trade has been historically yielding 5-6% on an annual basis. Dollar-yen carry trade delivered good return in 2024 when US interest rate stayed at around 5% and Bank of Japan (BOJ) kept interest rate close to zero. However, as the BOJ began tightening its monetary policy and Federal Reserve prepared for rate cuts, dollar-yen carry trade profitability shrank in 2025. The trade became riskier and volatile as the spread narrowed, reducing margins from around 5% to 3.75%.
Low exchange rate volatility: Stable exchange rate ensures that profits from interest rate spread are not eroded by foreign exchange losses. It works best when the funding currency (yen in the above example) does not appreciate sharply and the target currency (high-yielding currency, US dollar in the above example) appreciate slowly.
Low market volatility: When investors’ risk appetite is strong and market participants have confidence in global growth, carry trade usually works well. In a calm market, carry trade can provide steady returns, while it can unwind quickly during crises.
Predictable monetary policy: Carry trade can be profitable when monetary policy is stable and predictable and changes in exchange rate are gradual. The funding currency’s central bank should be keeping interest rates low and is expected to do so for some time, while the target currency’s central bank should be either hiking interest rates or holding the rate high. Sudden hikes from countries with lower interest rates (funding currency rates, BOJ raising interest rates in the above example) can trigger losses.
Limited capital control and liquid financial market: Investors need to be able to freely borrow, convert and move capital between countries. Any restriction or illiquidity can trap positions or cause forced unwinding at an unfavorable price.
Investors must recognize the risks associated with carry trades outlined below:
Currency risk: When there is a sudden exchange rate appreciation of the funding currency (in the above example, if yen suddenly strengthens), the value of the foreign investment converted back to the funding currency (e.g., yen) drops sharply. Sudden appreciation of the funding currency can wipe out all the gains from the interest rate differentials.
Spike in volatility: When there is a recession, financial crisis, geopolitical shock, or an unexpected policy shift (e.g., a rate hike or intervention), these can trigger a “flight to safety” causing a massive unwinding of carry trades. Investors will rush to pay back their funding loans and buy back the funding currency, selling higher-yielding assets to exit carry
trade simultaneously, which will amplify the volatility in the financial market.
Credit or liquidity squeezes: During a financial crisis, rapid unwinding of carry trade can cause sharp market sell-offs. Lenders can demand early repayment of the loans, or increase lending spreads, forcing investors to liquidate positions in the worst moments. During the 2008 financial crisis, the Japanese yen surged as carry trades were unwound massively and simultaneously, even though interest rates in Japan were still near zero.
Carry Trade Case Study
The following example illustrates a yen-Australian dollar carry trade in practice, showing how it profits in a calm market and how it can lose money when the exchange rate moves adversely.
Funding currency: Japanese yen (JPY) with interest rate at 0.1% per year
Target currency: Australian dollar (AUD) with interest rate 4.5% per year
Investment amount: Borrow ¥10,000,000
Initial exchange rate: 1 AUD = 80 JPY
Let’s suppose you take out a one-year loan of ¥10,000,000 at 0.1% annual interest rate. After one year, you will owe ¥10,000,000 * 1.001 = ¥10,010,000. Afterwards, you exchange ¥10,000,000 to AUD at the rate of 80 JPY per AUD. ¥10,000,000 / 80 = A$125,000. Now you invest A$125,000 in an Australian government bond or term deposits at 4.5% per annum. After one year, your investment will grow to A$125,000 * 1.045 = A$130,625. At the end of the year,
you will have to sell AUD investment and convert the proceeds back into JPY at the exchange rate at that time in order to repay the loan in yen. Your profit or loss will depend on the exchange rate after one year.
Scenario 1: When the exchange rate stays the same
The AUD/JPY rate remains at 80 and you convert A$130,625 back to yen: A$130,625 * 80 = ¥10,450,000. After repaying the loan of ¥10,010,000, there will be net profit of ¥440,000 (4.4% return on the initial ¥10,000,000). The profit will be the difference between 4.5% – 0.1% = 4.4% (interest rate differential) when there is no currency impact.
Scenario 2: When the AUD appreciates
Now consider the scenario where the AUD appreciates to 1 AUD = 88 JPY. When you convert A$130,625 back to yen at the new exchange rate, it will be: A$130,625 * 88 = ¥11,495,000. After repaying ¥10,010,000, the net profit will be ¥1,485,000 (14.9% return on the initial investment of ¥10,000,000), as you gain from the interest rate differential as well as a favorable exchange rate move.
Scenario 3: When the AUD depreciates
Now the AUD depreciates to 1AUD = 75 JPY. When you convert A$130,625 * 75 = ¥9,796,875. After repaying the loan of ¥10,010,000, there will be net loss of ¥213,125 (2.1% loss on the initial investment of ¥10,000,000). Although you can earn 4.5% yield on AUD investment, the 6.25% depreciation of AUD has wiped out all the profits.
The primary profit driver of carry trade is a wide and stable interest rate differentials, combined with a stable and steady appreciation of the target currency. Even a modest exchange rate move can quickly offset interest gains and in a live leveraged trading environment, adverse move in exchange rate can trigger a substantial loss or forced liquidations. Consequently, carry trades can thrive in a low-volatility, risk-on environment and can unravel when volatility spikes and funding currencies appreciate sharply (much like the yen in times of flight to safety).