The FX Carry Trade

If uncovered interest parity held exactly, borrowing a low-rate currency to buy a high-rate one would earn nothing extra on average — the high-rate currency would be expected to weaken by just enough to cancel the rate gap. It usually doesn't weaken by that much. The carry trade is simply the strategy of borrowing low-rate currencies and holding high-rate ones anyway, collecting the interest-rate gap as if it were a risk premium rather than a wash, because historically it mostly has been.

How the position is built

A trader borrows currency L at its low rate $r_L$, converts it to currency H, and deposits it at the higher rate $r_H$, leaving the position open (unhedged) rather than locking in a forward — hedging the currency risk with a forward would earn the rate gap back to the market and erase the profit, by covered interest parity. The expected return is:

$$\text{carry return} \approx (r_H - r_L) + \Delta S_{H/L}$$

In words: the return is the interest-rate gap you collect from holding the high-rate currency, plus (or minus) whatever the exchange rate does over the holding period. The trade is profitable as long as the high-rate currency doesn't depreciate by more than the rate gap — and empirically, it tends to hold steady or even appreciate for long stretches, which is exactly what makes carry a persistently profitable strategy on average, not just a coin flip.

Worked example

A trader borrows JPY at 0.50% and buys AUD deposits at 4.50%, a 4-point carry, on notional JPY 500,000,000 (≈$3.3m at 150 USD/JPY, converted through AUD at the prevailing cross). Over one year, if AUD/JPY is roughly flat, the trader collects the 4-percentage-point rate gap: about JPY 20,000,000 (≈$133,000) in interest, funded on borrowed yen. But if a risk-off shock hits and the yen — a classic safe-haven, low-rate currency — spikes 8% against AUD as leveraged carry positions unwind all at once, the trader loses roughly twice the year's accumulated carry in the currency move alone, wiping out this year and part of last year's profit.

What this means in practice

Carry unwinds tend to be sudden and self-reinforcing: everyone is on the same side of the trade, funded on similar low-rate currencies, so a shock that pushes a few players to close positions forces the funding currency to rally, which triggers margin calls on the rest, which pushes the currency further — the mechanism behind several historic yen and franc spikes.