Central bank policies, particularly those related to interest rates, directly influence carry trades. If a central bank raises interest rates in a low-yielding currency, the transaction becomes less profitable. Unwinding occurs when investors begin to exit their carry trade positions, often because of changing market conditions or rising costs in the funding currency.

The amount won’t be exactly $12 because banks use an overnight interest rate that fluctuates daily. Gordon Scott has been an active investor and technical analyst a girl’s guide to personal finance or 20+ years.

Profiting From Forward Bias

This change led to a sharp appreciation of the yen, causing many investors to unwind their carry trade positions. Between July and August 2024, the yen rose 14% against the U.S. dollar in less than a month, forcing many carry traders to liquidate their positions. This example highlights why carry traders need to monitor central bank policies and global economic conditions closely to assess the continuing viability of these strategies.

Why Investors Use Carry Trades

If the Swiss franc were to strengthen significantly against the Brazilian real or South African rand, investors would have to convert more of the local currency back into CHF, reducing or even eliminating profits. Also, as carry trades generally involve a lot of leverage, even a small movement in exchange rates can result in huge losses, unless the position is appropriately hedged. Here, investors borrow in a low-interest currency and then invest in higher-yielding currencies or bonds from emerging markets. The potential returns can be great, but these trades are highly sensitive to global market conditions and shifts in investor sentiment.

Understanding a Currency Carry Trade

• Volatility carry trade strategy is effective in stable markets but carries high risk if market volatility spikes unexpectedly.
• But if the yen gets stronger and the dollar stays the same, the trader will earn a smaller profit, or even lose money on the trade.
• A major risk is currency risk, where unfavorable fluctuations in the exchange rate can erode profits or lead to losses.
• As of the 2025 tax year, the capital gains tax rate tops out at 20%, while the marginal tax rate for ordinary income can be as high as 37%.
• Traders identify a currency pair where one currency has a significantly lower interest rate compared to another.

The trader benefits from the currency gain if the Australian dollar appreciates against the yen. The currency gain on the AUD enhances the overall returns of the carry trade. Carry trade positions in long-term timeframes are held for months or even years to maximize interest rate accrual.

• Furthermore, the carry trade strategy needs a certain level of risk tolerance, a decent understanding of global economic dynamics, and the ability to analyse trade positions actively.
• The profitability of carry trades comes into question when countries that offer high interest rates begin to cut them.
• Under the loophole, investment manager compensation is considered part of the fund’s investment profits, which are taxed as capital gains.
• Automation in carry trading uses algorithmic trading systems or bots programmed to monitor interest rate differentials, exchange rates, and other relevant market conditions.

What the Research Says About Profits in Carry Trades

Carry trades are common among institutional investors like hedge funds and large financial firms that can take advantage of leverage and interest rate differentials. However, individual investors also participate in carry trades, particularly in the forex market. Another well-known carry trade is borrowing in yen and investing in U.S. dollars (USD).

Forex traders can stay on top of them by visiting the websites of their respective central banks. For example, overconfidence can lead traders to underestimate the risks of currency fluctuations or interest rate changes. In addition, the fear of missing out (FOMO or regret avoidance) can drive traders to enter positions before undertaking enough analysis, leading to significant losses.

Traders borrowed in Yen and invested in higher-yielding currencies like the AUD (interest rate surpassed 7% in 2008), NZD (interest rate reached 8.25% in 2007), or emerging market currencies. Carry trades provide predictable cash flows through interest income from the higher-yielding investments. The steady income stream is beneficial for investors seeking regular returns, such as income-focused portfolios or those managing cash flow needs. The ability to forecast these cash flows adds a layer of certainty to carry trade investment strategies. Carry trade is a financial strategy where investors borrow money in a currency with a low interest rate and invest it in a currency with a higher interest rate. Carry trade is done to profit from the interest rate differential between the two currencies.

Create a basket of a few currencies that yield high and a few that yield low. A failure of one of the currency pairs involved won’t result in a wipeout of your entire portfolio. The Japanese Yen has been a go-to instrument for those trading carry through the 2010s and into the 2020s.

Traders rely on the power of compounding in long-term timeframes where interest payments accumulate over time and provide steady income regardless of short-term currency fluctuations. Longer holds are ideal when there’s confidence in the stability of the currencies involved and the durability of the interest rate differential. The long-term approach gives traders more time to ride out volatility and still profit from cumulative interest on the carry trade, even if currency appreciation is minimal. Forex traders track market sentiment and economic conditions through Forex broker platforms.

You might consider touching base with a top Forex broker first if you’re considering wading in. You’ll remain in a profitable position as long as the interest you’re charged to borrow one asset is less than the interest you’ll receive for the asset you buy. The already struggling USD/JPY pair plunged from around 155 to under 142 in a matter of days in a cascade of liquidations. Traders closing their positions created additional pressure on the dollar, forcing even more traders to liquidate. However, if the financial environment changes abruptly and speculators are forced to carry trades, this can have negative consequences for the global economy. For those who wish to dig a bit deeper into this puzzle, it’s good to quickly review what academics and practitioners have said.

Cutting interest rates brings interest rates to very low or near-zero levels. The narrow or even nonexistent interest rate differential eliminates the appeal of carry trades and makes them largely unprofitable. Risk tolerance is extremely low as investors prioritize capital preservation by avoiding riskier trades, such as carry trades, in favor of safe-haven assets. Currency stability is poor for high-yielding currencies, as market sentiment shifts toward stability and safety. Investment flows retreat further from high-yield currencies as capital moves to low-risk options, such as government bonds, gold, and currencies, like the USD and JPY.

In 2024, changes in Japan’s monetary policy caused the yen to strengthen, leading to a wave of carry trade unwinding and market turbulence​. The difference between a carry trade and an arbitrage lies in their time horizons, risks, objectives, and execution methods. Traders use dynamic hedging to adjust the hedge position in a carry trade over time to respond to changing market conditions.

Currency Carry Trades 101

Leverage in a carry trade necessitates careful management because it exposes investors to greater financial risks in volatile markets. Similarly, changes in interest rates by central banks can alter the interest rate differential, affecting the viability of the carry trade. If the central bank of the target currency raises rates, the trade may become more profitable.