Carry trade definition
A carry trade is a strategy that involves borrowing at a low-interest rate and investing in an asset that provides a higher rate of return.
Carry trades typically involve borrowing in a low-interest rate currency and converting the borrowed funds into a high-interest rate asset. The proceeds of the high-interest rate asset are then close out in the original low-interest currency.
Carry trades can be used in forex, stock, commodities, or any other asset denominated in a currency with a higher-interest than your own base currency.
Carry trade strategy explained
Say, for example, that Japan’s key interest rate is 0.5% and in the US it’s 2.5%. You could borrow yen and convert it into dollars, then use those dollars to invest in an asset that pays the 2.5% return.
If you’re only paying 0.5% interest on the yen you borrowed, then you can keep the 2% difference as profit.
However, carry trades are at the mercy of uncertain exchange rates.
If the US dollar (USD) falls in value versus the yen (JPY), the trader risks losing money. These transactions use leverage, so even small movements in exchange rates can cause significant losses unless the position is hedged.