The carry trade explained, and why it can unwind so quickly

A carry trade aims to earn the difference between two countries' interest rates. It is one of the oldest strategies in currency markets, and one of the most crowded.

How it works

1. Borrow in a currency with low interest rates, the funding currency.
2. Hold a currency with higher interest rates, the target currency.
3. Earn the difference, as long as the exchange rate doesn't move against you.

For a retail trader, a carry trade is simply a position that earns a positive swap: buying the higher-yielding currency against the lower-yielding one and holding it overnight. The swap is credited or charged each day at the broker's rollover.

The Japanese yen has long been the classic funding currency because Japanese rates were very low for decades. Pairs such as AUD/JPY have been typical carry trades.

A simplified example. Say the funding currency's policy rate is 0.5% and the target currency's is 4.5%, a 4-percentage-point gap. Holding a position worth the equivalent of ¥1,000,000 in the target currency for a year, and ignoring the broker's markup and any exchange rate movement, the interest rate gap alone works out to roughly ¥40,000 over the year. In practice the position is marked to market and swap is paid daily rather than once a year, exchange rates rarely stand still for that long, and the broker's own swap rate (see below) decides what actually lands in the account, not the headline rate gap.

Where the risk is

The interest income is small and steady; exchange rate moves can be large and sudden. A few days of adverse movement can wipe out months of carry.

Carry trades also tend to be crowded. When many traders hold the same positions and something frightens markets, they all try to close at once. Closing a yen carry trade means buying back yen, which pushes the yen up and forces more traders out.

That happened on 5 August 2024. A rapid unwinding of yen carry trades coincided with a 12.4% fall in Japan's Nikkei 225 index, its worst day since 1987, and a sharp jump in the yen.

Check the swap your broker actually pays

The interest rate gap between two countries isn't what you receive. Brokers add a markup to overnight financing, so a pair with a modest rate differential can show a negative swap on both the buy and the sell side. Check the swap rates in the instrument's specification on your platform before assuming a trade earns carry.

When carry tends to work

Carry strategies have historically done best in calm markets with low volatility and stable or widening interest rate gaps. They tend to suffer when volatility spikes, when the funding currency's central bank raises rates, or when authorities intervene. The yen's recent history includes all three: see currency intervention explained and safe-haven currencies.