Carry trade explained: learn the fundamentals of carry trade in no time

• A carry trade in forex means buying a high-interest-rate currency against a low-interest-rate currency
• The profit comes from the interest rate difference  and favorable exchange rate changes
• Carry trading is a long-term trade strategy (months or even years of holding)
• Carry trade is most effective when leverage is used

The first step in setting up a carry trade is to determine which two currencies will be involved. 

The currency that has the higher interest rate of the pair is called the carry currency. This is the one that you are buying.

The currency with the lower interest rate is called the funding currency.  As the name suggests, this is the borrowed money that you use to buy the carry currency.  A widely used funding currency is the Japanese yen (JPY) as the Japanese central bank often engages in monetary stimulus by lowering interest rates. 

In practice, when you do a carry trade, you borrow/sell the funding currency to purchase the carry currency. 

Where does the profit come from?

When trading currencies, you pay interest on the currency position you sell and collect interest on the currency position you buy. If you pay a low interest rate on the currency you borrowed/sold and you collect higher interest on the currency you purchased, you are making money. 
In other words, your profit comes from the difference between the two interest rates involved. You may realize additional profit if the exchange rate of your currency pair moves in favor of you trade. More on this later. 

The difference between interest rates is expressed in percentage. If your carry currency has a 5% interest rate, and your funding currency has a 2% interest rate, your profit will be 3%, provided both exchange rate remained the same during the time of your trade. This is of course a simplified example but it illustrates the mechanics of carry trading.

If you use leverage, your profit (or loss) on a carry trade will scale. For a carry trade to be truly lucrative, you will need to hold your position for months at least, but it is not uncommon to hold these positions for years.

In addition, exchange rate movement can also work to your benefit. If the high-interest currency appreciates against the low-interest currency during the time your position is open, you will gain profit on the exchange rate movement as well as the interest rate differential. 

If, however, the high-interest currency depreciates against the low-interest currency, you will lose on this exchange rate movement, but still profit from the interest rate differential. If the exchange rate remains the same, you will pocket the profit from the interest rate differential alone. 

Risks of carry trade:

• Interest rate changes: if the interest rate of the low-interest-rate (funding) currency increases and/or the interest rate of the low-interest-rate (carry) currency decreases, your profit will decline. The monetary policies of central banks are key to a carry trade strategy, mainly with respect to the future directions of interest rates.

• Exchange rate: if the market moves against the direction of your trade, you stand to lose money on the trade and your loss on the exchange rate movement could potentially wipe out the profit you realize on the interest rate differential.

In order to execute a carry trade, you will need a brokerage account. If you want to make it easier for yourself, make sure to check out our best forex brokers article, where you will have all the necessary information in one place.

Let's assume you enter the following hypothetical trade: 

• You open a long USD/CAD position (you buy USD, sell CAD). 
• You use $1,000 of your own money and 1:20 leverage, so the position size is $20,000
• You hold the position for 1 year

Assuming that the USD interest rate is 5% and the CAD interest rate is 2%, the interest rate differential will be 3%. In this trade, your carry currency is the USD, and you will be borrowing/selling CAD (the funding currency) to fund the trade. 

Since the leverage is 1:20, the 3% annual interest rate profit will translate into 60% annual profit.

If you close the position after 1 year, you will have earned $1,000 * 0.6 = $600 from the interest rate differential alone. 

For this outcome to materialize, the following two assumptions must be true:

• The interest rates stayed the same throughout the year

• The exchange rate did not move against the direction of your trade (i.e. the USD did not depreciate against the CAD)