A carry trade is a strategy in which a currency with a low interest rate is borrowed and the funds are invested in a currency or asset with a higher interest rate. The goal is to profit from the interest rate differential, known as the “carry.”
This strategy is especially common in the foreign exchange market and has historically often involved the Japanese yen as a funding currency, due to Japan’s long period of very low interest rates.
Carry trades tend to perform best in stable market conditions with low volatility. However, during periods of market stress, they can unwind rapidly as positions are closed on a large scale.
In addition to interest income, the strategy carries significant exchange rate risk, which can quickly reduce or even outweigh the interest advantage.
