How Global Finance Works
The Carry Trade
How investors borrow in low-interest currencies to invest in high-interest ones, why this can be profitable for long periods, and why it can unwind violently.
The carry trade is one of the simplest and most popular strategies in global finance, and one of the riskiest.
How it works
- Borrow in a currency with low interest rates, such as the Japanese yen, which had near-zero rates for many years.
- Convert the money into a currency with higher interest rates, such as the US dollar, Australian dollar or emerging market currencies.
- Invest in bonds or deposits in the high-rate currency.
- Earn the difference in interest rates, called the carry.
The catch: currency risk
If the high-yield currency falls against the funding currency, losses can wipe out the interest gains. Carry trades are often described as “picking up pennies in front of a steamroller”: steady small gains with occasional large losses.
Why carry trades move markets
- When many investors use the same trade, they push up high-yield currencies and push down funding currencies.
- If conditions change - for example, the funding currency’s interest rates rise or markets panic - investors rush to unwind trades at once, causing sharp moves.
The yen carry trade unwind
In August 2024, after the Bank of Japan raised interest rates and US economic data weakened, investors rushed to unwind yen carry trades. The yen jumped, and global stock markets fell sharply. Japan’s Nikkei index had its biggest one-day fall since 1987 before rebounding.
Emerging markets
Carry trades can bring hot money into emerging markets with higher interest rates, including India. When conditions change, the money can leave quickly, weakening currencies and raising volatility.
Why it matters for policy
Central banks in emerging markets watch carry trade flows because they can cause sudden currency swings. Holding foreign exchange reserves helps manage such episodes.
An investor borrows yen at near-zero interest and invests in US bonds paying 5 percent. For months, he earns steady profits. Then the yen strengthens 10 percent in a few weeks, wiping out more than a year of interest gains in a few days.
It earns steady gains but carries currency risk that can produce sudden, large losses.
- The carry trade borrows in low-rate currencies to invest in high-rate ones.
- It earns the interest difference but faces currency risk.
- Mass unwinding can cause sharp market moves, as in August 2024.
- Carry flows can bring volatile hot money into emerging markets.
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