A currency carry trade takes a long position in a higher-interest-rate currency funded by a short position in a lower-interest-rate currency, leaving the exchange-rate exposure unhedged. Its income comes from the interest-rate differential, but its final profit depends on what the investment currency buys when the position is closed. A positive rate spread can accompany a cash loss.
The cash version is straightforward: borrow the funding currency, exchange it for the investment currency, and deposit or lend the proceeds. Carry exposure can also be created with currency forwards or futures; a literal bank loan is not essential. The Federal Reserve's discussion of carry-trade definitions explains both implementations.
Follow both currencies to maturity
Consider a fictional one-year trade. USD is the funding and reporting currency; the other currency is simply called “foreign.” Every exchange quote below means USD per foreign unit. These are invented rates, not current market quotes. Both borrowing and deposit rates are fixed simple rates for the full year. Ignore spreads, fees, defaults and early liquidation.
Borrow USD 100 at 1%. At a spot quote of 1.00 USD per foreign unit, buy 100 foreign units and deposit them at 5%. At maturity:
- The deposit pays 105 foreign units: 100 principal plus 5 interest.
- The dollar loan requires USD 101: USD 100 principal plus USD 1 interest.
- Suppose the final spot quote is 0.95 USD per foreign unit. Selling the deposit proceeds returns USD 99.75.
The resulting dollar profit and loss is
Original synthetic cash-flow ledger. Both rates are fixed simple one-year rates; the trade has no fees, default, bid-ask spread or early exit. All exchange quotes are USD per foreign unit.
The rate spread is 4 percentage points. With an unchanged spot quote, this particular trade would earn USD 4. Instead, the foreign currency depreciates by 5% against USD, reducing the dollar value of the whole deposit, including its interest. The spread is not a guaranteed percentage return on the trader's capital: that return also requires a specified amount of equity or collateral.
For help reading conversion direction before adding the funding legs, the FX primer develops currency quotes and the two interest rates. Its full lesson requires a free signed-in account.
How far can the investment currency fall?
Let be dollars borrowed, and be initial and final quotes in USD per foreign unit, and and be the two simple one-year rates. The terminal dollar P&L is
The rate advantage and currency move interact: foreign interest is itself exposed to foreign-exchange risk. Setting the ledger to zero gives this example's break-even quote:
The corresponding depreciation cushion is only about 3.81%, calculated as . A final quote below the exact threshold loses money; a quote above it earns money under these assumptions. Transaction costs would reduce the cushion.
Hedging changes the trade
Covered interest-rate parity compares hedged funding strategies. In the idealised model with matched maturity, credit and borrowing/lending terms, the one-year forward quote is
Selling all 105 foreign units forward at this rate locks in USD 101, exactly enough to repay the debt. The higher deposit rate does not create a covered arbitrage profit. Actual funding and execution constraints require a fuller ledger.
Uncovered interest-rate parity concerns expected future spot movements rather than an exchange rate locked by contract. It does not fix the realised conversion price. The San Francisco Fed's explanation separates that expectation argument from the exchange risk borne by carry traders.
Why an orderly carry can unwind abruptly
A funding-currency appreciation makes repayment more expensive in investment-currency terms. With leverage, adverse moves can also trigger a margin call or forced sale before the intended holding period ends. Traders closing similar positions sell investment currencies and buy funding currencies, which can intensify the move. The BIS describes this mechanism in its account of the August 2024 carry unwind.
The relevant risk question is therefore wider than “which currency pays more?” It includes how the exchange rate, collateral needs and available funding behave together during stress.
Sources
- Federal Reserve Bank of San Francisco — Interest Rates, Carry Trades, and Exchange Rate Movements, Michele Cavallo, 17 November 2006.
- Federal Reserve — What Can the Data Tell Us about Carry Trades in Japanese Yen?, Joseph E. Gagnon and Alain P. Chaboud, July 2007; definition and leverage discussion.
- BIS — Carry off, carry on, September 2024; carry unwinding and funding-currency appreciation.
- John C. Hull, Options, Futures, and Other Derivatives, 9th Global Edition, Pearson, 2018, §5.10, pp. 139–142; currency funding replication and foreign-currency interest income.