In plain English
What Carry trade means
The basic structure is to borrow or sell a lower-rate funding currency, then buy a higher-rate target currency or an asset denominated in it. The potential carry is the yield difference after funding and transaction costs. However, exchange-rate losses can outweigh that income, particularly if the target currency falls or leveraged positions are rapidly unwound.
Why it matters
Carry trades link interest-rate differences, FX funding markets, leverage, and volatility. They can appear attractive when exchange rates are stable, but their risk is not limited to the overnight financing figure. Changes in monetary policy expectations, market stress, liquidity, or risk sentiment can cause sharp currency moves and increase losses on leveraged positions.
Example
Assume a position earns an annualized 4% yield advantage before costs on $100,000 of exposure, implying roughly $4,000 over a year if rates and the exchange rate stayed unchanged. If the target currency then depreciates 6% against the funding currency, the simplified exchange-rate loss is $6,000, exceeding the carry income.
Quick answers
Common questions
What is the main risk in a carry trade?+
The principal risk is an adverse exchange-rate move. A target currency can depreciate enough to exceed the interest-rate differential. Leverage can magnify that loss, while changing funding costs and reduced market liquidity can further worsen the outcome.
Is a carry trade the same as an FX swap?+
No. A carry trade is an investment or trading strategy based on relative funding and yield. An FX swap is a transaction that exchanges currencies now and reverses the exchange later at a pre-agreed rate; it can be used to implement funding or hedging arrangements.
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