Carry Trades in Forex

A forex carry trade borrows in a currency with low interest rates and invests in a currency with higher rates, earning the difference. For retail traders, this means going long a high yielding currency pair and collecting positive rollover each night. Carry trades have been one of the most persistent sources of return in currency markets, but they are vulnerable to sudden, violent unwinds when markets panic. The general strategy across all asset classes is covered in Carry Trading; this lesson focuses on currencies.

How it works#

1. Choose a funding currency with low rates, historically the Japanese yen or Swiss franc.
2. Choose a target currency with higher rates, such as the US dollar, Mexican peso, Australian dollar or other emerging market currencies at times.
3. Go long the target against the funding currency, for example long USD/JPY or long MXN/JPY.
4. Collect the rate difference through daily rollover. See Rollover and Swap in Forex.
5. Hope the exchange rate stays stable or moves in your favour.

Return components#

carry trade return ≈ interest differential + exchange rate change

Why carry has worked on average#

According to uncovered interest parity, high yielding currencies should fall by the rate differential, removing any gain. Research, including work by Burnside, Eichenbaum and Rebelo and by Lustig and Verdelhan, has found that this often did not happen: high yield currencies did not depreciate enough on average, leaving a profit. Explanations include compensation for crash risk and for exposure to global downturns. See Covered and Uncovered Interest Parity and Carry Factor.

Carry crashes#

Carry returns are negatively skewed: steady gains punctuated by sharp losses. Unwinds happen when risk appetite collapses and traders rush to repay funding currencies.

• October 2008: during the global financial crisis, AUD/JPY fell roughly 40% between August and late October as yen funded carry trades unwound. See The 2008 Financial Crisis.
• January 2015: the Swiss National Bank removed its franc cap, and the franc surged about 30% against the euro in minutes, devastating short franc positions. See Central Bank Intervention.
• August 2024: after the Bank of Japan raised rates and US growth fears rose, the yen jumped sharply. USD/JPY fell from around 162 in July to near 142 in early August, and global markets sold off as yen carry positions unwound.

Managing carry risk#

1. Keep leverage low. Carry gains are small relative to potential currency moves. See Leverage and Margin in Forex.
2. Diversify across several high and low yielders rather than one pair.
3. Combine with trend filters: reduce or exit carry when the high yielder is in a downtrend. See Trend Following.
4. Watch volatility: carry trades tend to suffer when FX volatility rises. Some strategies cut exposure when implied volatility jumps. See Implied Volatility (IV).
5. Watch funding currency policy: a hawkish turn from the Bank of Japan or Swiss National Bank can trigger unwinds. See The ECB and the BOJ.
6. Use options to cap downside, such as buying puts on the high yielder. See FX Options.

Positioning data#

Traders watch the CFTC Commitments of Traders reports for crowded positions in yen and other currency futures. Extreme short yen positioning has often preceded sharp yen rallies. See Sentiment Data.

Common mistakes#

• Focusing on the swap and ignoring price risk.
• Using high leverage because daily returns look calm.
• Concentrating in one exotic pair with high political risk.

Frequently asked questions#

What is a carry trade in forex?#

A strategy that holds a high interest rate currency funded by a low interest rate currency, earning the rate difference through rollover.

Why is the yen used for carry trades?#

Because Japanese interest rates have been very low for decades, making the yen cheap to borrow.

What causes a carry trade unwind?#

Sudden risk aversion, rising volatility or changes in central bank policy that push traders to close positions and repay funding currencies, causing sharp moves.

Next, learn how governments act directly in currency markets in Central Bank Intervention.