What Is a Carry Trade? Strategy, Examples, and Risks

What Is a Carry Trade?

A carry trade is a trading strategy where you borrow money in a currency that has a low interest rate, then use it to buy a currency that offers a higher interest rate. The goal is to earn the difference between the two rates, known as the "carry."

Carry trades have been popular at different times in history. One well-known example is the Japanese yen carry trade in the early 2000s, when traders borrowed yen at very low rates to invest in higher-yielding currencies like the Australian dollar.

This strategy is most common in the forex market, but it’s also used in other areas like fixed income and derivatives trading where interest rate differences matter.

How a Carry Trade Works

Here’s how a carry trade works:

1. Choose a low-interest currency: Traders look for a currency with a very low interest rate, like the Japanese yen (JPY) or Swiss franc (CHF). This is called the “funding currency.”

2. Borrow or sell that currency: The trader borrows the low-yield currency or sells it short.

3. Buy a high-interest currency: The borrowed funds are used to buy a currency that offers a higher interest rate, such as the Australian dollar (AUD), New Zealand dollar (NZD), or South African rand (ZAR).

4. Hold the position: As long as the position is open, the trader earns the difference in interest rates between the two currencies. This is called the “positive swap.”

The success of a carry trade depends on the gap between the interest rates of the two currencies. Central banks set these rates, so their policies play a big role. If the difference narrows because of interest rate changes, the trade becomes less profitable, or even unprofitable.

Swap and Rollover in Forex

In forex trading, positions held overnight earn or pay interest through what’s called a “swap” or “rollover.” If you're in a carry trade, you usually earn interest when holding a position with a positive rate differential. But if the differential is negative, you’ll be charged instead.

Carry trades also often use leverage, meaning traders borrow money to control a larger position. This can boost profits if the trade goes well, but it also increases risk. A small move in the wrong direction can lead to big losses, especially in volatile markets.

Positive vs. Negative Carry Trade

The terms “positive” and “negative” carry refer to whether the interest rate difference between two currencies works for you—or against you.

Positive Carry Trade

• You earn interest: This happens when the currency you buy has a higher interest rate than the one you sell.

• Goal of most carry trades: Traders aim to hold these positions to collect the interest rate difference daily (called a positive swap).

• Example: Borrowing in Japanese yen (0.1% interest) and buying the Australian dollar (4% interest). The trader earns the 3.9% difference—minus any fees.

Negative Carry Trade

• You pay interest: This occurs when the currency you buy has a lower interest rate than the one you sell.

• Unfavorable swap: Instead of earning interest, you’re charged a fee each day you hold the position.

• Why would someone do this? Sometimes traders accept a negative carry because they expect the currency to move strongly in their favor, enough to offset the cost.

• Example: Borrowing in AUD (4%) to buy JPY (0.1%) would result in paying the interest difference.

So in short:

• A positive carry trade earns you interest daily.

• A negative carry trade costs you money daily.

• The key factor is the interest rate gap between the two currencies involved.

Why Carry Trades Are Popular

Here’s why traders use carry trades:

Passive Income Potential

One of the main reasons carry trades are attractive is that they can generate passive income. By holding a position in a high-interest currency, traders can earn interest daily without needing to buy or sell.

Works Well in Stable Markets

Carry trades tend to perform best when markets are calm and currencies are stable. In low-volatility environments, there’s less risk of sudden price swings that could wipe out the interest gains.

Extra Profit from Currency Movement

Sometimes, traders not only earn the interest rate difference but also benefit if the high-yield currency gains value. This means there's a chance to profit both from the swap and the exchange rate.

Simple Strategy with Long-Term Potential

Compared to more complex strategies, carry trading is relatively straightforward. Many traders use it as a long-term approach, holding positions for weeks or even months to collect interest over time.

Carry Trade vs. Arbitrage

While both strategies aim to profit from market inefficiencies, they work in very different ways.

Cary Trade:

• Based on interest rate differences: In a carry trade, you borrow in a low-interest currency and invest in a high-interest one.

• Time-dependent: You need to hold the position over time to earn the interest rate differential (the “carry”).

• Exposed to market risk: Currency values can change, which means the trade can become unprofitable even if the interest rate gap stays the same.

• Not risk-free: It involves real exposure to price movements and central bank policy changes.

Arbitrage:

• Based on price differences: Arbitrage involves buying and selling the same asset in different markets to profit from price gaps.

• Usually instant: The goal is to lock in a risk-free profit quickly before the price difference disappears.

• Low or no market risk: True arbitrage doesn’t depend on holding positions over time, it exploits temporary pricing mismatches.

• Examples: Triangular arbitrage in forex or exploiting differences in currency prices across brokers.

Risk Management in Carry Trades

Carry trades can be profitable, but they also carry significant risks, especially when leverage is involved or market conditions change quickly. Here are a few ways traders manage those risks.

1. Use Stop Loss and Take Profit Orders

Setting a stop loss helps limit how much you can lose if the trade moves against you. A take profit order locks in gains when the market hits your target level. These tools add structure and reduce emotional decision-making.

2. Monitor Central Bank Policies

Interest rates can shift suddenly due to changes in central bank policies. Staying informed about economic news, inflation data, and rate decisions is key to avoiding surprises that can turn a profitable carry trade into a losing one.

3. Limit Leverage

While leverage can increase profits, it also magnifies losses. Using high leverage on a carry trade can be risky, especially if the market becomes volatile. Many traders reduce position size and keep leverage low to stay safe.

4. Diversify Your Positions

Putting all your funds into one carry trade pair can be risky. Instead, some traders spread their capital across multiple pairs or use other strategies to balance their portfolio and reduce exposure to a single currency.

5. Hedge When Necessary

Advanced traders may use options, futures, or cross-currency trades to hedge against unexpected market movements or interest rate changes. While this adds complexity, it can help protect larger or longer-term positions.

How Central Banks Affect Carry Trades

Central banks play a key role in carry trades because they set the interest rates for their currencies. These rates determine the potential profit or loss from holding a carry trade.

• When a central bank raises interest rates, its currency becomes more attractive in carry trades. Traders may buy that currency to earn higher returns.

• When a central bank cuts rates, the currency becomes less appealing, and existing carry trades may lose value.

Sudden rate changes or unexpected policy shifts can cause sharp moves in the forex market, which can either boost or break a carry trade. That’s why traders closely watch central bank decisions, speeches, and economic reports.

Conclusion

Carry trading is a widely used forex strategy built on the interest rate differences between currencies. While it can offer steady returns through positive swaps, it also carries important risks, especially when markets are volatile or interest rates shift unexpectedly.

By understanding how carry trades work and applying proper risk management, traders can use this strategy more effectively and with greater confidence.