Borrowing in Yen to distribute dividends worldwide: Why do interest rate spread trades make investors both love and fear?

The concept of carry trade may seem simple—borrowing in low-interest-rate currencies and investing in high-yield assets to profit—but in recent years, it has become one of the most explosive and risky trading strategies in the global financial markets. Especially since the Federal Reserve’s aggressive rate hikes in 2022, this strategy has regained market attention and sparked numerous discussions about risks.

The Logic Behind Carry Trade

The core idea of carry trade is straightforward: using the interest rate differentials of currencies across the globe to make investments, earning the interest spread by holding high-yield assets. This strategy is most commonly seen in the foreign exchange market, hence also called “interest rate arbitrage.”

Simply put, when Taiwan’s bank loan interest rate is only 2%, and U.S. fixed deposits offer a 5% return, the 3% gap constitutes the profit space for carry trade. Theoretically, borrowing 2 million TWD to buy $100,000 worth of assets could earn a 30,000 TWD interest differential in one year.

However, many investors overlook a key variable: Exchange rate fluctuations can directly wipe out or even reverse these paper profits. In 2022, the TWD/USD exchange rate was around 1:29, but by 2024, it had depreciated to 1:32.6. This should theoretically bring additional gains. But in the case of Argentina, despite the government raising interest rates to nearly 100%, the peso depreciated by 30% overnight, completely offsetting the high-interest advantage.

Three Hidden Risks to Watch Out For

The risks behind carry trade are far greater than what appears on the surface:

Exchange rate risk is the most intuitive—no one can accurately predict currency movements. A currency from a country raising interest rates may not necessarily appreciate, and a country lowering rates may not necessarily see its currency depreciate. These involve complex variables such as economic fundamentals, political factors, and capital flows.

Interest rate change risk is often overlooked. When central bank policies shift, the interest rate differential can narrow rapidly. The Taiwanese insurance industry is a vivid example—fixed-income policies with 6%–8% returns, once common, now see deposit rates drop to 1%–2%, turning these products into a heavy burden for insurers. The same applies to leveraged real estate investments: when rental income exceeds mortgage interest, it seems profitable, but if the rental market weakens or mortgage rates rise, the interest spread can turn into a loss instantly.

Liquidity risk concerns exit ability. Not all financial products can be easily sold; some assets bought at 100 may only sell for 90, and after transaction fees, losses increase. Long-term products like insurance contracts, where policyholders can cancel but insurers cannot, can trap investors when interest spreads deteriorate.

Using Derivatives to Lock in Risks

In practice, many hedging transactions use forward foreign exchange contracts (SWAPs) to lock in exchange rates. For example, a Taiwanese manufacturer with a $1 million overseas order due in one year, now exchanging at 32.6 million TWD, can enter into a forward contract to fix the exchange rate. Although this incurs a cost, it helps avoid unforeseen risks like currency gaps during holidays or sudden jumps.

However, in actual operations, companies usually do not lock the entire amount from start to finish, because the locking cost eats into expected profits. They only hedge partially when facing specific risks.

Yen Carry Trade: The Golden Era of the Past

The largest global carry trade historically involved borrowing in Japanese yen. Japan became the preferred choice because it offers political stability, relatively stable exchange rates, and most importantly, extremely low—sometimes negative—interest rates.

The Bank of Japan has implemented loose monetary policies for years to stimulate inflation, objectively encouraging borrowing. In contrast, Europe, despite experiencing zero interest rates, has rarely been a source of international arbitrage borrowing, mainly because European investors tend to be more conservative and the region lacks policies like Japan’s.

Two typical yen arbitrage strategies are:

The first involves international investors borrowing Japanese yen at 1% interest from the Bank of Japan, then investing in high-yield bonds and stocks in the U.S. or Europe, using the dividends to pay back the yen loans, with the remaining profit used to repay principal early or accumulate gains. Since borrowing costs in yen are extremely low, even if the exchange rate moves unfavorably, the overall investment can still be profitable.

The second is stock arbitrage. During the post-pandemic period of massive central bank liquidity, Warren Buffett believed U.S. stocks were overvalued and turned to favor Japanese stocks. He issued bonds through Berkshire Hathaway in Japan, then invested the proceeds in high-quality Japanese listed companies. By gaining boardroom influence, he pushed these companies to increase dividends and buy back shares, while also demanding higher liquidity and reducing cross-shareholdings. In just two years, this strategy yielded over 50% profit, and because it involved borrowing in yen to invest in Japanese stocks, it completely avoided exchange rate risk—this is true low-risk arbitrage.

Carry Trade vs Arbitrage: The Fundamental Difference

Many people confuse these two concepts, but in reality, arbitrage (arbitrage trading) usually refers to riskless profit—where the price difference of the same asset across different markets is quickly eliminated. For example, selling Bitcoin at $80,000 on Exchange A and buying at $78,000 on Exchange B, then quickly completing the trade with no cost, is arbitrage.

Carry trade, on the other hand, is fundamentally a risk-taking investment—investors must wait for interest to accrue, bear exchange rate fluctuations, and face risks from changes in interest rate policies. This is the most fundamental difference between the two.

Keys to Successful Carry Trade

To make carry trade effective, timing the trade cycle is crucial. Investors must determine in advance how long they are willing to hold the position to select suitable high-yield assets.

Second, they should study the historical trend patterns of their investment targets. Although USD/TWD exchange rates are influenced by multiple factors, they often exhibit identifiable trends during certain periods. Recognizing these patterns can significantly improve trading success rates.

Finally, successful carry traders need to continuously monitor the relationship between global currency interest rates and exchange rates, building their own data tracking systems. This allows timely adjustments before the interest rate spreads narrow.