The currency carry trade is one of the oldest and most widespread strategies in the markets: borrow where money is cheap, invest where it pays more. Simple in appearance, it carries a risk of reversal that can be brutal.
1 What is the carry trade?
Profiting from the rate gap between two currencies.
Definition
Borrow low, invest high
The carry trade consists in borrowing in a low-interest-rate currency, then placing the proceeds in another currency, or in assets, that pay more. The investor pockets the difference in yield. The yen, kept at near-zero rates for decades, was long the funding currency par excellence.
2 How it works
Three steps, and often a fourth: leverage.
①
Borrow low. In the funding currency, at a low rate (the yen, for example).
②
Convert and invest high. In a target currency or assets that pay more.
③
Pocket the spread. As long as exchange rates and interest rates do not move against you.
3 Why it appeals
An income that seems to fall into your lap.
🪙Steady income
The rate spread is collected as long as nothing moves.
⚙️Leverage
Borrowing to invest multiplies the return.
🌍Global scale
A single funding source can irrigate entire markets.
4 The risk of reversal
The danger comes from the exchange rate, and from the crowd.
The unwind
If the funding currency appreciates, or its rate rises, the cost of funding climbs and the gains reverse. Because many players use the same strategy with leverage, the exit becomes a stampede: the selling pushes the funding currency up, which deepens the losses and forces further selling. This “unwind” can be brutal and spread to entire markets.
5 Takeaways
To remember.
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The carry trade: borrow low, invest high, pocket the spread.
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The yen, at near-zero rates, was long its reigning funding currency.
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Leverage amplifies gains and losses alike.
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The real risk is a currency reversal, which can trigger a spiralling unwind.
This notion illuminates an analysis