What is Carry Trade?

Introduction to Carry Trade

In the dynamic world of Forex trading, the carry trade stands out as a strategy that transforms interest rate differences into trading opportunities.

It involves borrowing in a currency with a low interest rate and investing in one that offers a higher yield.

The aim? To profit from the interest rate differential—known as the “carry”—while potentially also gaining from favourable exchange rate movements.

At its core, the carry trade is not about predicting rapid market moves, but about earning steady returns through interest income over time.

That makes it particularly attractive to traders with a long-term, macroeconomic outlook. Yet, it’s not without risks—market volatility, interest rate shifts, and geopolitical tensions can all influence outcomes.

Unlike fast-paced strategies like scalping or day trading, the carry trade requires patience and a keen eye on central bank policy.

It’s rooted in economic fundamentals and is especially popular during periods of stable markets and rising interest rate divergence between countries.

Understanding this strategy is essential for traders who want to diversify their approach and take advantage of the global nature of Forex.

Whether you’re new to trading or a seasoned investor exploring new opportunities, grasping the carry trade could be a step toward building a more robust strategy.

Explore how carry trading fits into your long-term forex strategy by opening a free demo account with AvaTrade today.

How the Carry Trade Works: Step-by-Step Scenario

To truly understand the mechanics of a carry trade, let’s walk through a practical example. This scenario will demonstrate how profits (or losses) are made—not only from the interest rate differential but also from currency movements.

Hypothetical Scenario:

Trader Profile: A Forex trader, looking to capitalise on stable interest rate disparities.

1. Identify the Pair
   The trader notices that the Reserve Bank of Australia (RBA) has set interest rates at 4.35%, while the Bank of Japan (BoJ) maintains rates at just 0.10%. This creates a potential carry spread of 4.25% annually.
2. Enter the Trade
   He/she borrows 10,000,000 JPY (Japanese yen) at a low interest rate and converts it into 100,000 AUD (Australian dollars) to buy high-yielding assets or hold the currency.
3. Hold Position
   While holding the position, she earns the interest differential—assuming daily rollover swaps apply and no major currency fluctuations occur. If he/she holds for a year, the gross interest income could be approximately AUD 4,250, minus any broker fees or swap adjustments.
4. Exit the Trade
   After 12 months, he/she converts their AUD back to JPY. If the AUD/JPY exchange rate remains stable or moves in their favour, the trader keeps the full carry gain and might even benefit from capital appreciation.
5. Risk Considerations
   However, if the AUD depreciates significantly against the JPY, the principal value drops—possibly eroding or exceeding the interest gains. Likewise, if the BoJ raises rates or the RBA cuts them, the spread narrows or reverses.

This scenario shows that while the carry trade can generate income through interest differentials, it is not risk-free.

Currency volatility, leverage, and unexpected central bank actions can all affect results. That’s why professional traders monitor macroeconomic trends and risk indicators closely before committing capital.

Carry Trade Risks and How to Manage Them

While the carry trade offers the allure of steady returns through interest rate differentials, it carries several layered risks that every trader must understand before executing the strategy.

Failing to assess and manage these risks can quickly turn a profitable setup into a costly mistake.

Key Risks Involved in Carry Trading

1. Exchange Rate Risk
   The most prominent risk is currency volatility. If the high-yielding currency (e.g. AUD) depreciates sharply against the funding currency (e.g. JPY), losses can outweigh any interest income. For example, a 5% drop in AUD/JPY can eliminate a year’s worth of carry gains in a matter of days.
2. Interest Rate Reversal
   Central banks don’t hold rates constant. If the interest rate differential narrows—due to a rate cut in the high-yield currency or a hike in the funding currency—the carry trade becomes less profitable or even negative.
3. Leverage Risk
   Many carry trades use leverage to amplify returns. However, this also magnifies losses. A small adverse move in the exchange rate can result in margin calls or forced liquidations.
4. Geopolitical and Macroeconomic Events
   Events such as elections, wars, or unexpected economic data releases can rapidly destabilise markets. Safe-haven flows can strengthen funding currencies like the yen, making carry trades vulnerable.
5. Liquidity Risk
   During periods of market stress, liquidity can dry up—especially in exotic currency pairs—leading to slippage and widening spreads.

Best Practices for Carry Trade Risk Management

• Use Stop-Loss Orders: Always set predefined exit levels to protect your capital from major drawdowns.
• Avoid Overleveraging: Stick to moderate leverage ratios and ensure sufficient margin buffers.
• Monitor Central Banks: Stay informed about upcoming rate decisions and policy statements from key central banks.
• Diversify Across Pairs: Don’t rely on a single currency pair; diversify your carry trades to spread risk.
• Stay Updated on Global News: Use economic calendars and news feeds to stay ahead of potential market-moving events.

By understanding and actively managing these risks, traders can navigate the carry trade strategy with greater confidence and resilience—turning it from a passive yield play into a robust component of a balanced forex portfolio.

Stay one step ahead—follow central bank updates and market insights on AvaTrade’s economic calendar.

Best Currency Pairs for Carry Trade

The success of a carry trade hinges on selecting the right currency pair—specifically, one that combines a high interest rate differential with low volatility and strong macroeconomic support.

While conditions evolve, certain currencies have historically stood out as go-to options for this strategy.

Top Funding Currencies (Low-Yielders)

These currencies are commonly borrowed due to their low interest rates:

• Japanese Yen (JPY): A classic funding currency for decades, thanks to Japan’s persistently ultra-low rates.
• Swiss Franc (CHF): Another low-yielding option, backed by Switzerland’s stable economy.
• Euro (EUR): Often used in recent years during periods of ECB policy easing.

Top Investment Currencies (High-Yielders)

These currencies are typically bought in carry trades:

• Australian Dollar (AUD): Known for higher interest rates and a strong commodity-based economy.
• New Zealand Dollar (NZD): Offers attractive yields and a relatively stable monetary framework.
• Mexican Peso (MXN): Often used in aggressive carry strategies, but with higher volatility.

Popular Carry Trade Pairs

Considerations When Choosing a Pair

• Monetary Policy Outlook: Focus on central banks signalling long-term divergence in interest rates.
• Political Stability: Avoid high-yield currencies from countries with unstable governments or weak fiscal discipline.
• Liquidity: Stick to pairs with strong volume and low spreads unless you’re an experienced trader.

Carry trades aren’t just about picking the “highest spread.” It’s a delicate balance between yield and risk.

Choosing well-established pairs with strong economic backing enhances both profit potential and trading stability.

Expert Commentary & Historical Insights

To deepen your understanding of carry trading, it’s useful to hear how seasoned analysts interpret its potential—and to see how this strategy has played out in real markets.

Carry trades aren’t just a theory; they’ve been a driving force behind major global capital flows.

Expert Perspective:

“The carry trade thrives when volatility is low and central bank policies diverge. Traders must remain vigilant, as shifts in macroeconomic sentiment or risk appetite can unwind positions rapidly.”
— Mark McCormick, Global Head of FX Strategy at TD Securities
(Source)

This underscores a key point: the carry trade works best in calm, predictable environments. Once market sentiment changes or geopolitical tension rises, these trades can quickly become vulnerable.

Historical Example: The Yen Carry Trade (Pre-2008)

For much of the early 2000s, Japan maintained interest rates near zero. Traders worldwide borrowed massive sums in yen and invested in higher-yielding currencies like the Australian dollar or British pound.

This strategy pumped billions into emerging markets and helped fuel global asset bubbles—until the 2008 financial crisis struck.

Investors rushed to unwind their yen positions, causing the yen to surge and triggering huge losses on carry trades.

This period remains one of the clearest demonstrations of the double-edged nature of carry trading: steady gains during stable times, but swift reversals when volatility spikes.

More Recent Trends

In 2022–2023, with the Federal Reserve and other central banks aggressively raising rates, carry trades re-emerged—particularly with the US dollar vs. yen or Swiss franc. However, sharp policy pivots and global inflation shocks kept traders cautious.

By analysing both expert views and historical events, traders gain a better sense of when carry trades offer true opportunity—and when they might be best avoided.

Conclusion & Key Takeaways

The carry trade remains a compelling strategy in the forex trader’s toolkit—especially for those who understand the interplay between interest rates, macroeconomics, and market sentiment.

By borrowing in low-yielding currencies and investing in high-yielding ones, traders can potentially generate passive income through interest differentials while also seeking capital gains from favourable currency moves.

But it’s not a “set-and-forget” tactic. Carry trading demands awareness of risks—especially exchange rate volatility, leverage exposure, and sudden shifts in monetary policy.

As we’ve seen from both expert insights and historical events, timing and risk management are everything.

Key Takeaways

• Carry trades profit from interest rate differentials, often executed via borrowing low-yield currencies like JPY or CHF and investing in higher-yielding ones like AUD or MXN.
• The strategy suits macro-focused, patient traders, particularly in low-volatility, trend-stable environments.
• Risks include currency swings, central bank shifts, and geopolitical shocks—all of which must be actively monitored.
• Proper execution involves strong discipline, diversified exposure, and the use of trading tools like stop-loss orders, economic calendars, and risk calculators.

Whether you’re just exploring forex strategies or looking to refine your portfolio, mastering the carry trade opens the door to a new layer of trading insight—one that rewards knowledge, patience, and strategic positioning.

Ready to put your knowledge into action? Open a live trading account with AvaTrade and explore carry trading with competitive spreads, swap transparency, and world-class platforms.

Frequently Asked Questions (FAQ)

• Is carry trading suitable for beginners?

  Carry trading is best suited to traders with a basic understanding of forex and economic indicators. While the concept is straightforward, it requires careful monitoring of interest rate trends, currency movements, and risk exposure. Beginners can start with a demo account to gain confidence before trading live.

   
• What are the best currency pairs for carry trading in 2025?

  Currency pairs like AUD/JPY, NZD/JPY, and USD/TRY are commonly used in carry trades due to their strong interest rate differentials. However, conditions change regularly, so it’s essential to monitor central bank policy and market sentiment before choosing a pair.

   
• How does leverage affect a carry trade?

  Leverage can amplify both gains and losses. While it allows traders to increase exposure and maximise interest income, it also magnifies the impact of adverse currency movements. Managing leverage responsibly is crucial in carry trading.

   

• Can I lose money in a carry trade even if the interest rate differential is positive?

  Yes. A negative shift in the exchange rate can erode or exceed the gains from the interest differential. For example, if the high-yielding currency depreciates significantly, your overall position could end in a loss despite earning daily interest.