Currency Carry Trade

Currency carry trade refers to the strategy of buying a currency with a higher interest rate while simultaneously shorting the currency with the lower interest rate. The investor profits from the yield differential as long as the exchange rate doesn’t move too negatively against him. For example, if the Australian Dollar yielded 7% a year and the Japanese Yen yielded 0.5% a year, an investor could buy the Australian Dollar and short the Japanese yen. This would result in a 6.5% gain per year. As long as the Japanese Yen appreciates less than 6.5% against the Australian Dollar that year, the investor profits.

However, currency carry trades can be risky as interest rates may fluctuate and the interest rate differential may change, and exchange rate risk exists as well.

Carry trades are typically popular during eras of low risk aversion and are often liquidated during eras of high risk aversion, causing large volatility.