Carry Trade Explained: How It Works and When It Fails

A carry trade uses cheaper funding to hold an investment with a higher yield. In a currency carry trade, that usually means borrowing in a currency with a low interest rate and investing in another currency that pays more.

The interest difference is only part of the result. If the currency you borrowed strengthens, the currency loss can exceed the interest advantage.

How a currency carry trade works

The basic transaction has four steps:

1. Borrow in the funding currency, where your borrowing rate is lower.
2. Exchange it for the investment currency.
3. Hold an interest-paying asset in that currency.
4. Convert the proceeds back and repay the loan, including interest.

What remains is the profit or loss. It depends on the borrowing cost, the investment’s return, the exchange rate and transaction costs.

Large investors can also use derivatives to create similar exposure without taking out a cash loan.

On a retail account, holding a margined forex position can involve an overnight financing adjustment, often called a swap. Whether it’s a charge or a credit depends on the instrument, trade direction and provider’s terms.

When traders consider a carry trade

Traders consider carry when the expected income exceeds funding costs and other charges, and they expect the investment currency to hold its value or strengthen against the funding currency. A relatively calm market can make carry more attractive: income builds gradually, while a currency move affects the whole position at once. The trader also needs funding for the planned holding period, including cash to meet any margin requirements.

Carry trade example: borrow yen and invest dollars

Here, USD/JPY means yen per US dollar. A quote of 150 means $1 buys ¥150. If it falls to 140, each dollar buys fewer yen: the yen has strengthened against the dollar. The forex guide explains how currency pairs are quoted.

Assume the following hypothetical terms:

• Borrow ¥1,500,000 at 1% for one year.
• Convert it at USD/JPY 150 to receive $10,000.
• Place the $10,000 in a dollar deposit earning 5% over that year.
• Both rates are fixed for the year, and the deposit pays back principal and interest in full.
• Initially, ignore transaction costs, taxes and any collateral requirements. Leave the exchange rate unhedged.

These are illustrative borrowing and deposit rates, not current central-bank rates or an IQ Option offer.

At the end of the year, the dollar deposit is worth $10,500. The yen loan requires a repayment of ¥1,515,000.

If the exchange rate stays at 150

Convert the $10,500 back into yen:

$10,500 × 150 = ¥1,575,000

Then repay the loan:

¥1,575,000 − ¥1,515,000 = ¥60,000 profit

That is 4% of the original ¥1,500,000 borrowed, before other costs. It matches the four-percentage-point interest difference because the exchange rate hasn’t changed. It is not a return on the trader’s own capital; that would require knowing how much capital or collateral they supplied.

If the yen strengthens

Now suppose USD/JPY finishes at 140. The deposit still pays $10,500, but those dollars convert into fewer yen:

$10,500 × 140 = ¥1,470,000

The loan repayment hasn’t changed:

¥1,470,000 − ¥1,515,000 = −¥45,000

The trade loses 3% of the original amount borrowed, despite earning more interest than it paid. If USD/JPY rises instead, the conversion works in the trader’s favour.

How much currency movement wipes out the carry?

In this example, the break-even rate is the yen repayment divided by the dollars available:

¥1,515,000 ÷ $10,500 ≈ 144.29 yen per dollar

A fall of about 3.81% in the USD/JPY quote, from 150 to that level, erases the year’s interest advantage before other costs.

The underlying calculation is:

P/L in yen = $10,500 × closing USD/JPY − ¥1,515,000

Now assume ¥6,000 in additional transaction costs, separate from the interest already included. At an unchanged exchange rate, the profit falls from ¥60,000 to ¥54,000. The break-even rate rises to about 144.86 because more yen are needed to cover the costs.

These are one-year outcomes. A trade closed after a month hasn’t earned a full year’s interest.

Why the yen is used in carry trades

The yen became a common funding currency during periods when Japanese interest rates were low relative to those elsewhere. Investors could borrow yen and seek a higher yield in another currency. The Reserve Bank of Australia’s account of Japanese carry trading describes both the interest incentive and the effect of exchange-rate reversals.

That history isn’t a standing instruction to sell yen. The relevant comparison is the borrowing rate available to you against the return available on the investment, for the same period. Policy rates, market funding rates and retail borrowing costs aren’t interchangeable.

What happens when carry trades unwind?

To unwind a cash carry trade, the investor sells the foreign investment, buys back the funding currency and repays the loan. If many investors do this together, their purchases can push the funding currency higher. That makes the remaining positions more expensive to repay and can prompt further exits.

July and August 2024 provide a real example. The yen reversed its earlier weakening trend, and leveraged yen-funded positions came under pressure. The BIS’s analysis of the August turbulence found that unwinding and higher margin requirements amplified market moves following US economic news. It also identified other leveraged strategies as part of the episode.

Carry trade vs the swap on a forex position

The swap on a retail forex position isn’t simply the difference between two central-bank policy rates. Market funding conditions, broker charges and the rollover schedule affect the actual amount. Long and short positions can have different terms. Check whether the displayed figure is an annual percentage, a daily amount or an amount per lot—and what its sign means.

The swap calculator helps translate those terms into a holding-period estimate. Use the current rate for the specific instrument and count chargeable days, including any weekend or holiday adjustments.

For a separate hypothetical example, suppose a position earns a $2 credit per chargeable day for 10 days. It collects $20. If its price loss is $200 and other costs are $6, the result is −$200 + $20 − $6 = −$186.

If the platform charges you to hold that direction, there is no positive overnight income to collect. The trade could still profit from a price move, but that is a different source of return.

What can change while the trade is open?

Borrowing costs and investment income

Floating-rate funding can become more expensive, and the income available when an investment is renewed can fall. Either change narrows the carry.

A central-bank rate change doesn’t rewrite the fixed one-year rates assumed in our example. It can, however, change exchange rates immediately and affect the terms available when the loan or deposit matures.

Margin and leverage

A small margin deposit can support a much larger currency position. Losses follow the exposure, not just the deposit. If losses or higher margin requirements exhaust the available funds, the position may be closed before the expected interest has been earned.

Compare the effect of a currency move with the amount of cash available to support the trade. The leverage calculator helps distinguish position value from margin.

The investment itself

The example assumes a deposit that pays in full. Other carry trades may hold bonds or riskier assets. A bond can fall in price before maturity, an issuer can fail to pay, and selling during stress can be difficult. A higher stated yield can come with more risk than the currency exposure alone.

Can you hedge the currency risk and keep the interest difference?

A currency forward lets you agree today on an exchange rate for a future conversion. That rate generally differs from today’s rate because forward pricing reflects the interest-rate difference between the currencies.

In the textbook case, the forward rate offsets the interest advantage. Actual quotes and funding costs can differ, so you need to calculate the result using the terms available to you. Hedging doesn’t simply remove currency risk while leaving the same four-percentage-point gain.

What to check before considering a carry trade

Start with the actual terms, rather than a ranking of countries by interest rate:

• Income and funding: what will you receive and pay over the intended holding period, after charges?
• Currency exposure: which direction hurts the position, and what would that move cost in your account currency?
• Ability to stay in the trade: how much cash could be needed if prices move against you or margin requirements rise?
• Exit conditions: what change in rates, price or funding would make you close the position?

Calculate a losing scenario alongside the unchanged-rate case, using the same holding period and costs for both.