Carry trade: meaning, example and why it can unwind fast

Some global investors borrow money where it is cheap and invest it where returns are higher. This is called a carry trade. This page explains how a carry trade works, a well-known example and why these trades can reverse suddenly.

Quick answer

A carry trade is a strategy where an investor borrows money in a currency with low interest rates and invests it in assets of a currency with higher interest rates. The profit, called the carry, is the interest rate difference. The main risk is that the borrowed currency strengthens or the invested currency weakens, which can wipe out the gain quickly.

Key takeaways

• A carry trade borrows cheap and invests where rates are higher.
• The profit is the interest rate gap, called carry.
• Currency moves can erase the gain quickly.
• The Japanese yen has long been a popular funding currency.
• A sudden unwind can cause sharp falls across markets.

What is a carry trade?

Interest rates differ between countries. When one country's rates are very low and another's are higher, an investor can borrow in the low-rate currency, convert the money and put it into higher-yielding assets, such as bonds.

As long as exchange rates stay stable, the investor earns the difference between the two interest rates. This difference is the 'carry', which gives the strategy its name.

A simple example

Suppose an investor can borrow Japanese yen at almost zero percent and invest in Indian government bonds yielding around 6 to 7 percent. If the rupee stays steady against the yen for a year, the investor keeps most of that gap, minus costs.

The risk appears when the yen rises against the rupee. The investor must repay yen that are now more expensive in rupee terms. A large enough move can turn the trade into a loss.

Why can carry trades unwind so fast?

Many investors often run similar trades, sometimes with borrowed money. When something changes, such as a rate hike in the funding country, many rush to close positions at once. They sell the high-yield assets and buy back the funding currency.

This happened in early August 2024. After the Bank of Japan raised its policy rate at the end of July, the yen rose sharply. Global markets fell, and Japan's Nikkei 225 index dropped about 12 percent on 5 August 2024 alone. Many analysts linked this to the unwinding of yen carry trades.

Why does it matter for India?

India's interest rates are usually higher than those in Japan, the US or Europe. This can attract carry trade money into Indian bonds and other assets, which may support the rupee for a time.

When carry trades unwind, foreign investors may pull money out quickly, putting pressure on the rupee and on share and bond prices. So global rate changes and currency moves matter for Indian markets, even if they start far away.

The key point to remember

A carry trade earns the gap between interest rates but carries real currency risk. It can work quietly for a long time and then reverse very fast, which is why it is watched closely during periods of global stress.

The securities and commodities named here are mentioned only to explain how the market works and are not a recommendation to buy, sell or hold them.

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