A carry trade is a strategy that borrows or sells a currency with a low interest rate and uses the proceeds to hold a currency with a higher interest rate, aiming to earn the difference between the two — the interest-rate differential. The trade profits from the rate gap as long as the exchange rate does not move enough against the position to wipe out that yield.
How Does a Carry Trade Work?
The idea is to capture the gap between two countries’ interest rates. A trader funds the position in a low-yield currency and invests in a high-yield one, collecting the differential over time.
Suppose one currency carries a 0.5% deposit rate and another carries 5.5%. Funding in the first and holding the second targets roughly the 5-percentage-point spread per year, before costs — provided the exchange rate stays broadly stable.
Why Are Carry Trades Risky?
The yield is steady, but the currency move is not. If the higher-yielding currency falls sharply against the funding currency, the exchange-rate loss can exceed the interest earned, sometimes quickly.
Carry trades also tend to unwind together in stressed markets, which can amplify moves. The strategy is often described as collecting small, regular gains while exposed to occasional large losses.
Carry Trade vs. Covered Interest Parity
In theory, covered interest parity says forward exchange rates already price in the interest-rate differential, so a fully hedged version of this trade earns nothing. The carry trade leaves the exchange-rate risk unhedged — that open exposure is precisely where both the potential return and the risk come from.
Related Terms: Interest Rate Differential, Covered Interest Parity, Swap Points, Spot Rate. See the full glossary for more.
This is educational content, not financial or trading advice.