Forex Carry Trade

A forex carry trade is the term given to a transaction that involves the exchanging of a currency with very low interest rate, for a currency (or other form of security) with a much higher interest rate. The goal is to use or borrow the lower-yielding currency with its much lower cost of acquisition to gain a position in a much higher yielding currency or security. The difference between what you earn and what you pay to borrow the first currency is known as carry and is retained as profit.

The carry trade became very popular during the 1990s and early 2000s when the Bank of Japan kept interest rates for the most part, under one percent. If you were a resident of Japan or conducted business in Japan, keeping yen at a commercial bank meant that you were essentially earning no interest on your savings.

Meanwhile, other countries such as Australia and New Zealand had interest rates in the five to seven percent range during the same time and investors began exchanging yen for these other currencies which were paying much higher interest. Thus, the forex carry trade gained in popularity and so long as interest rates remained reasonably stable, four, five, and six percent profits were essentially guaranteed.

Foreign investors – particularly Americans – soon joined in and borrowed yen for the express intent of converting to a higher-yielding currency or other form of investment. They could almost always borrow yen at very favorable terms and use this money to enter into a forex carry trade.

The danger for investors of course, is that should the interest rate differential narrow, profits would be affected, perhaps to the point of actually losing money.