Carry Trade: How to Take Advantage of Interest Rate Differentials

How Does a Carry Trade Work?

A carry trade, known in English as “carry trade,” is an operation where capital is borrowed at a low-interest rate in one currency and invested in assets denominated in another currency with higher returns. The main goal is to capture the interest rate differential, known as the “carry,” without necessarily relying on the underlying asset’s value increasing.

This mechanism operates on a simple logic: if you can obtain financing at 0% or near-zero rates, and direct that capital into instruments generating a return of 5.5% or higher, that difference represents your potential profit. The trick is for the exchange rate to remain stable or move in your favor. If the opposite occurs, the gains quickly disappear.

The Appeal to Large Market Participants

Hedge funds, financial institutions, and wealth managers find this strategy attractive because it generates predictable income without requiring asset prices to rise. For years, the most iconic example of the carry trade was the yen-dollar: cheap loans in Japanese yen reinvested in higher-yielding U.S. assets. It was practically a “money-making machine” as long as conditions remained favorable.

Many operators amplify this strategy through leverage, borrowing much more capital than they actually own. This multiplies potential gains but also exponentially increases losses when something goes wrong.

Risks Facing This Operation

The biggest danger is exchange rate risk. If the currency you borrowed in appreciates relative to the investment currency, you could lose not only your gains but also part of the original capital. For example, if you borrow yen and the yen appreciates against the dollar, when you repay the loan in yen, it will cost more money than expected.

Fluctuations in interest rates pose another threat. A central bank unexpectedly raising its rates increases your financing costs, eroding margins. Conversely, if interest rates fall in the investment destination, your income decreases.

History offers clear lessons on these risks. During the 2008 financial crisis, multiple operators holding positions in carry trades suffered massive losses when markets disintegrated. More recently, in July 2024, the Bank of Japan implemented unexpected changes in its monetary policy, causing the yen to surge. This triggered a domino effect: investors abruptly closed yen positions, liquidating risk assets to obtain dollars and meet their obligations. The impact spread globally, shaking currency markets and causing massive sales of more volatile investments.

Calm Markets vs. Stress Scenarios

These operations thrive in calm and optimistic environments, where volatility is contained and investors have risk appetite. In these contexts, exchange rates move predictably and interest rates remain relatively stable.

However, when economic uncertainty arises or volatility spikes, the landscape changes radically. Highly leveraged markets become fragile. Contagious panic can trigger cascading liquidations, where large and small participants close their positions simultaneously, amplifying price movements. What started as a profitable strategy can turn into a generator of uncontrolled losses.

Conclusion: A Strategy for Experts

The carry trade is a sophisticated tool to extract value from interest rate inefficiencies. However, it requires deep understanding of currency markets, central bank decisions, and prudent leverage management.

Only experienced investors and financial institutions with access to real-time technology, data, and information should consider it. For retail investors, the associated risks typically outweigh potential benefits, especially in volatile markets or amid unexpected changes in global monetary policy.

Risk warning: Digital and financial assets can experience extreme volatility. The value of your investments may decrease significantly or be completely lost. You are entirely responsible for your investment decisions. Seek advice from qualified professionals before committing capital to complex strategies like carry trades.