The idea
Every currency pays its own interest rate. Holding a currency with a high rate against one with a low rate earns the difference, paid daily as swap or rollover in forex accounts. Borrowing in yen or Swiss francs to hold higher-yielding currencies has been the classic version.
If exchange rates stayed put, the carry trade would simply earn the rate gap. In reality the pair moves, and occasionally falls sharply.
Watch it play out
Step by step
The rules
Setup
- A pair with a large and stable interest rate gap.
- Calm markets, with the pair not in a downtrend.
Entry
- Buy the high-rate currency against the low-rate one, and collect the daily swap.
Stop-loss
- A wide stop, or a rule to exit when market fear rises sharply.
Target
- Hold while the rate gap and calm conditions last.
Filters that help
- Watch central bank decisions that could narrow the gap.
- Keep leverage low: crashes are sudden.
Why it can work
Economic theory says high-rate currencies should fall by about the rate gap, cancelling the carry. In practice they often have not, at least in calm periods, so carry has earned money over long stretches. The catch is crash risk: in a panic, carry positions are unwound together and high-rate currencies drop fast.
Carry has also tended to pay most in calm, rising markets and lose in panics, which makes it behave like a bet on stability. That is useful to know before adding it to a portfolio that already depends on calm markets, such as one full of stocks.
Worked example
A pair pays a rate gap of about 4% a year. Over 30 weeks you collect roughly 2.3% in interest while the pair drifts up.
Then a risk-off scare sends it down 8.7% in three weeks, more than three times all the interest earned. That pattern, slow gains and sudden drops, is the carry trade's signature.
When it works, when it fails
Works best
In calm, risk-on periods with stable rate gaps.
Struggles
In panics, when everyone unwinds carry at once, as in the 2008 financial crisis and sharp yen rallies. Losses then are fast and large.
Common mistakes
- Using high leverage because the daily interest looks like free money.
- Ignoring central bank meetings that can close the gap.
- Holding through rising market fear.
Variations
- Carry with a trend filter
- Holding carry pairs only while they are also in an uptrend, which has historically avoided part of the worst unwinds at the cost of some carry.
- Diversified carry
- Holding several high-rate currencies against several low-rate ones, which spreads but does not remove crash risk.
What the evidence says
Evidence: ResearchedPublished studies exist. Results depend on the details and on costs.
The carry trade is one of the most studied strategies in finance. Research found it has earned money over long periods, against what theory predicts, but with crash risk: high-rate currencies tend to fall suddenly when funding dries up and risk appetite drops.
Hence researched: a real long-run premium that comes with occasional sharp losses.
Questions
- Which currencies are used in carry trades?
- Low-rate funding currencies such as the Japanese yen and the Swiss franc have often been borrowed to hold higher-rate currencies. Which pairs work depends on each period's interest rates.
- How is the carry paid in a forex account?
- As swap, also called rollover: a daily credit or debit for positions held overnight, based on the two rates. Brokers add their own margin, so the swap you receive is less than the full rate gap.
- What is a carry trade?
- Holding a currency with a high interest rate against one with a low rate and earning the difference, paid daily in most forex accounts.
- Why do carry trades crash?
- Because many traders hold the same positions. In a panic they all unwind at once, and high-rate currencies fall fast.
- What is swap or rollover?
- The daily interest credited or charged on a forex position held overnight, based on the two currencies' rate gap.