Borrow low and hold the high:the carry is the gap you buy.
A strategy in which a trader borrows a currency with a low interest rate to buy a currency with a higher interest rate, in order to collect the interest rate differential.
A move in the exchange rate can outweigh the interest, and carry trades have historically unwound quickly in periods of market stress.
In plain words
A carry trade means holding a currency that pays a higher interest rate, funded by a currency that charges a lower one, in order to collect the difference between the two rates. In a leveraged account that difference shows up as the swap, the daily interest adjustment applied to positions held overnight.
See it move
Target rate: the largest here
Why it matters
The interest difference is small compared with how far an exchange rate can move, so the outcome depends mostly on the exchange rate. Carry trades have historically unwound quickly in periods of market stress, when the higher-yielding currency falls.
Worked example
An example only. The figures are round and invented for the arithmetic: they are not market prices.
A trader holds a position worth 100,000 for a year in a currency yielding 5%, funded in one costing 1% (invented rates, broker charges ignored).
- 1Differential = 5% − 1% = 4%
- 2Interest collected = 100,000 × 4% = 4,000
- 3If the higher-yielding currency falls 6%100,000 × 6% = 6,000 lost
- 4Net = 4,000 − 6,000 = −2,000
A 6% fall in the exchange rate more than cancels a year of interest and leaves a loss of 2,000.
A common mistake
The interest difference is sometimes seen as income that arrives whatever happens. A move in the exchange rate can cost more than the interest earns, and with leverage that loss is magnified.
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Educational information, not investment advice or a recommendation to trade.