The carry trade explained: interest differentials, swaps and why carry trades unwind

A carry trade means holding a currency with a higher interest rate against one with a lower rate, so that you earn the difference between the two rates for as long as the position is open. Large investors do it by borrowing in the low-rate currency and investing in the high-rate one. A retail forex or CFD trader does it by buying the pair and receiving a positive swap each night.

The catch is that the interest arrives slowly while the exchange rate can move against you quickly. Carry trades have a long history of earning small amounts for long periods and then losing much of it in a few days when many holders exit at once, as happened with yen-funded positions in early August 2024.

The idea in one example

Imagine two currencies. Currency H has a central bank rate of 4%, currency L has a rate of 0.5%. If you could borrow L at 0.5%, convert it to H and deposit it at 4%, you would earn roughly 3.5% a year on the amount, as long as the exchange rate between H and L did not change.

That last condition is the whole story. If H falls 3.5% against L over the year, the interest gain is cancelled. If it falls 10%, you lose about 6.5% on the amount. If it rises, you gain twice: once from the interest and once from the exchange rate.

The low-rate currency is called the funding currency and the high-rate one the target or investment currency. The glossary has short definitions of the carry trade and the interest-rate differential that drives it.

Where the interest comes from: swaps

A retail trader does not borrow and deposit cash. When you hold a forex position past the daily rollover, the broker credits or debits a swap that reflects the interest differential between the two currencies, minus its own markup. Our guide to swap and overnight financing covers the mechanics in full, including why one rollover a week (usually Wednesday's) is charged three times to cover the weekend.

The short version:

• Buy the higher-yielding currency against the lower-yielding one and the swap can be positive: the broker pays you each night.
• Sell it and you pay the differential plus the markup.
• The markup applies in both directions. If the differential is small, both the long and the short swap can be negative.

So the carry you actually receive is always smaller than the headline gap between the two central bank rates. Before thinking about any carry position, look up the broker's current long and short swap for that symbol, usually shown in the contract specification inside the platform.

Worked example: from central bank rates to a nightly swap

These numbers are illustrative, not current rates. You buy 1 standard lot (100,000 units of the base currency) of AUD/JPY.

• Assume the Australian rate is 4.0% and the Japanese rate is 0.5%. The gross differential is 3.5%.
• On 100,000 AUD, 3.5% a year is 3,500 AUD, or about 9.59 AUD per night (3,500 ÷ 365).
• Assume the broker's markup is 1.0% a year. The net carry is 2.5%, or 2,500 AUD a year, about 6.85 AUD per night.
• On the triple-swap night you receive about 20.55 AUD, then nothing extra at the weekend.

The swap calculator lets you put your broker's actual swap points into the same calculation for any number of lots and nights.

Why the exchange rate dominates

Carry is a small, steady number. Exchange-rate moves are large and irregular. Comparing them in pips makes the point.

Worked example: how many nights of carry a move cancels

Continuing the illustrative AUD/JPY trade at a price of 100.00:

• One pip in AUD/JPY is 0.01 yen. On 1 standard lot, one pip is worth 1,000 yen, which at a rate of 100.00 is 10 AUD.
• The net carry is about 6.85 AUD per night, so each night's swap is worth roughly 0.7 pip.
• A 1% fall in AUD/JPY (from 100.00 to 99.00) is 100 pips, a loss of about 1,000 AUD. That is about 146 nights of net carry.
• A 5% fall (500 pips) is about 5,000 AUD, roughly two years of net carry on this example.

AUD/JPY moving 1% in a day is not unusual in volatile conditions, and our profile of AUD/JPY explains why it is so sensitive to shifts in risk appetite. The carry trade therefore behaves like a strategy that collects a small amount most days and occasionally gives back a large amount on a few days. The interest is the visible part; the exchange-rate risk is the larger part.

What leverage does to a carry trade

Leverage is what makes the carry trade look attractive to retail traders, and it is also what makes it dangerous.

Worked example: carry against margin

Illustrative numbers again. A trader with a 10,000 AUD account buys 1 lot of AUD/JPY at 100.00.

• AUD/JPY is not a major pair under ESMA's definition, so the retail leverage limit in the EU is 20:1. The margin on 100,000 AUD of notional is 5,000 AUD. Our guide to ESMA leverage limits explains the categories.
• The net carry of 2,500 AUD a year is 25% of the account. Many people stop the calculation there.
• A 5% fall in AUD/JPY costs about 5,000 AUD, half the account, and brings the margin level close to the point where a margin call or close-out begins. Our guide to margin calls and stop-outs shows how that sequence works.
• A 10% fall would wipe out the account before the trader had collected even half a year of carry.

The carry is measured on the notional amount, but so is the exchange-rate risk. Leverage does not improve the ratio between them; it only makes both larger relative to your money. Size carry positions from the stop distance and the maximum loss you can accept, exactly as for any other trade, as our position sizing guide describes.

Funding currencies and target currencies

Which currencies play which role changes with the interest-rate cycle, so treat any list as history rather than a standing fact.

• Funding currencies have tended to be those with very low rates for long periods. The Japanese yen is the best-known example, because Japanese rates stayed at or below zero for many years; the Swiss franc has also played this role. Our USD/JPY profile covers the yen's history.
• Target currencies have tended to be those with higher rates, which over different periods has included the Australian and New Zealand dollars and a number of emerging-market currencies.

When US rates rose well above Japanese rates in 2022 and 2023, simply holding US dollars against yen became a carry position in its own right, with the Federal Reserve's target range at 5.25–5.50% from July 2023 to September 2024 while the Bank of Japan kept its rates close to zero.

High-yield exotics

Some emerging-market currencies offer much larger interest differentials, but the broker's swap markups on exotic pairs are usually wider, spreads are higher, and the currencies can depreciate sharply over long periods. A large differential often reflects high inflation or other risks that the exchange rate also reflects. The pair profiles for USD/TRY, USD/ZAR and USD/MXN describe those risks, and our guide to exotic pair trading costs covers the spreads and swaps.

Why there is no automatic gain: interest parity

If borrowing cheaply in one currency and investing in another were a reliable gain, everyone would do it until it stopped working. Economic theory addresses this through interest parity.

• Covered interest parity says that the forward exchange rate already reflects the interest differential. If you lock in today's rate for a future date using a forward contract, the forward price adjusts so that the carry disappears. In practice, this relationship holds closely in major currencies, which is why forward points and swaps exist at all.
• Uncovered interest parity says that, on average, the high-yielding currency should depreciate by about the interest differential, so the expected gain from carry is zero. In practice, studies have often found that high-yield currencies did not depreciate as much as the theory predicts over long periods, which is the case for carry as a strategy. The counter-argument is that the extra return is compensation for crash risk: the occasional sharp falls described below.

Our guide to interest-rate differentials and currencies goes deeper into the theory and how it fits the evidence.

How carry trades unwind

Carry positions tend to be crowded. When many funds and traders hold the same trade, they are exposed to the same shocks. If something makes them want to reduce risk at the same time, they all buy back the funding currency at once. That buying pushes the funding currency higher, which inflicts losses on the remaining holders, which prompts more selling of the target currency. The move feeds on itself.

Common triggers include:

• A change in rate expectations, especially a funding-currency central bank raising rates or signalling it will.
• A rise in market-wide volatility, which makes the carry look small relative to the risk and prompts risk limits to bite. The VIX is often watched as a gauge of this.
• A sharp fall in equity markets or another risk-off shock.
• Margin calls, which force leveraged holders to close regardless of their view.

Funding currencies often behave as safe havens in these episodes, rising when riskier assets fall. That is partly because unwinding carry trades means buying them back.

August 2024: the yen carry unwind

The most recent large example is well documented. In early July 2024, USD/JPY traded above 160, around its highest levels since the 1980s, with a wide gap between US and Japanese rates. Japanese authorities intervened to support the yen in July.

On 31 July 2024, the Bank of Japan raised its policy rate to around 0.25% from a range of 0 to 0.1%, and signalled it could raise rates further. Two days later, on 2 August, US employment data came in weaker than expected, increasing expectations of US rate cuts. Both developments narrowed the expected gap between US and Japanese rates at the same moment.

Positions funded in yen were closed rapidly. USD/JPY fell to a low of around 141.7 on Monday 5 August, roughly 12% below its early-July peak in about a month. Japan's Nikkei 225 fell about 12.4% that day, its largest one-day percentage fall since the 1987 crash, and volatility measures across markets spiked. Much of the move in Japanese equities was reversed in the following days, but the episode is a clear illustration of how carry positions behave under stress: in about a month, the exchange-rate move was equal to more than two years of the gross interest differential between the dollar and the yen.

How traders think about carry risk

None of this means interest differentials are irrelevant. For anyone holding positions for weeks or months, the swap is a real cost or credit, and it is worth knowing before entering. Some of the ways experienced traders think about carry:

• Carry relative to volatility. A 3% differential on a pair that typically moves 15% a year is a very different proposition from 3% on a pair that moves 6% a year. The ATR indicator gives a rough sense of recent volatility.
• Direction of rates, not just the level. A differential that is expected to narrow (because the funding-currency central bank is raising rates or the target-currency one is cutting) is a weaker basis for carry than one that is stable. Our guide to central banks and interest rates covers how expectations move currencies.
• Correlation. Several carry positions funded in the same currency are really one large position. Our guide to currency correlation shows how to see the overlap.
• Weekend and gap risk. Carry positions are held for long periods, so they are exposed to every weekend gap. Our guide to gap risk and weekend risk covers what that means for stops.

Common mistakes

• Calculating carry against margin rather than notional, and seeing a large percentage return while ignoring that the exchange-rate risk scales the same way.
• Using central bank rates instead of the broker's swap. The markup can turn a positive differential into a negative swap.
• Holding without a stop because the position pays every night. A small daily credit does not protect against a large adverse move.
• Doubling up after the swap rate rises, without checking whether volatility has risen too.
• Ignoring changes in swap rates. Brokers update swaps as rates and their own costs change; a position that paid last month may cost this month.
• Treating swap-free accounts as carry-free. Swap-free accounts usually replace swaps with other fees and do not pay positive carry.

Frequently asked questions

Is the carry trade a good strategy for beginners?

It is a risky one, because it combines leverage, long holding periods and exposure to sudden, crowded exits. A beginner is usually better served by understanding swaps as a cost or credit on any position held overnight than by building positions around them. Most retail CFD accounts lose money, and leverage magnifies losses.

How do I earn the carry as a retail trader?

By holding a position that buys the higher-yielding currency against the lower-yielding one past the daily rollover, where your broker's swap for that direction is positive. The amount is set by the broker and is smaller than the gap between the central bank rates.

Why is my swap negative on both sides?

Because the broker's markup is larger than the interest differential. When two currencies have similar rates, the markup can make both the long and the short swap negative.

What caused the August 2024 carry trade unwind?

Several factors arrived together: the Bank of Japan raised rates on 31 July 2024 and signalled more, weaker US jobs data on 2 August raised expectations of US rate cuts, and many investors held positions funded in yen. As the expected rate gap narrowed, those positions were closed quickly, the yen rose sharply and global equity markets fell, with Japanese stocks hit hardest on 5 August.

Does the carry trade still work when rates are cut?

The trade depends on the differential, not the level of rates. If the target currency's central bank cuts, or the funding currency's raises, the differential narrows and the swap falls. Expectations of narrowing can move the exchange rate against carry positions before the swap changes.

Which currencies are used for carry trades?

It changes with the rate cycle. The yen and Swiss franc have historically been common funding currencies because of their long periods of very low rates, and higher-yielding currencies such as the Australian and New Zealand dollars and some emerging-market currencies have been common targets.