Carry Trade Strategy: Profiting from Interest Rate Differentials

30 June 2025

Exploiting the interest rate differential between currencies or assets of different countries has been a cornerstone of global finance for some time now. Investors and traders make money by borrowing in low-yielding currencies (like the Japanese yen) and investing in higher-yielding assets (like the U.S. Treasuries or Australian bonds). Traders can capture the rate difference between the two assets and generate income. The strategy was popularized in Japan due to the country’s low interest rates, which enabled the general population to invest their savings overseas and generate profits in the US markets. While the carry trade strategy is wildly popular in Forex markets, it also extends to bonds, commodities, and many other asset classes. Despite its obvious advantages, carry trade strategy risks can eliminate all the profits and traders need to be prepared to counter sudden exchange rate swings and market reversals, like when the 2024 yen rally erased years of gains overnight.

Carry trade strategy explained

Anybody can implement a simple carry trade FX strategy by knowing several core principles. Let’s first explain what a carry trade is and then switch to its formula calculations, and the central bank's role.

Carry trade is when a trader or investor borrows money in a jurisdiction where it is cheap and invests this borrowed money in a currency or any other asset where it has a higher percentage yield. For example, if you can borrow money in 1% and invest in a 5% dividend-generating stock, then you can make profits by capitalizing on an interest rate differential.

Carry trade FX strategy formula and calculations

The carry trade’s profitability relies on two components:

Interest differential
Exchange rate movements

For interest differential we need to calculate daily interest rate = [(IR~Long~ – IR~Short~) / 365] × Notional Value

Example: Long AUD/JPY (AUD rate = 5.1%, JPY rate = 0.1%) with $100,000 earns ≈$13.70 daily.

Exchange rate movements can amplify or decrease profits. Profits are amplified if the high-yield currency gains even more value and losses happen when this currency or asset depreciates below the interest rate. This is a critical moment to memorize when employing carry trade strategies. You should always check interest rates, and if central banks are announcing new rates, it might be a good idea to terminate the carry trade, especially if there are high chances of new rate announcements.

Role of Central Banks in Carry Trade Forex Strategies

Central bank policies are one of the most important factors when trying to deploy the forex carry trade strategy. Central banks dictate interest rates and fiscal policies and can directly affect the interest rate difference. Low-yield currencies often result from aggressive monetary stimulus from central banks, and high-yield currencies reflect tighter policies. The Japanese yen for example is known for low interest rates which were typically near 0%, meaning it would cost almost nothing to borrow the yen and use it for yield generation. For example, in 2024, the Bank of Japan (BOJ) increased its interest rates from -0.1% to 0.25% which was immediately followed by a 9% USD/JPU plunge, reflecting policy sensitivity.

Forward Premium Puzzle

In contrast to interest rate parity theory, high-yield currencies often appreciate instead of depreciate. This anomaly is known as the forward premium puzzle and enables investors to achieve persistent carry trade profits. However, sudden, strong reversals remain its Achilles’ hill.

Carry trade strategy examples and historical performance

Historically, the yen has been a go-to currency when trying to generate income from forex carry trade strategy as the interest rates were historically super low for the yen. As a result, a huge wave of traders started to use this strategy for profits. There was even a term developed: Mrs Watanabe or Kimono Trader, thousands of Japanese housewives who were investing while at home. These retail traders who were in charge of household savings traded the carry trade strategy so successfully that it became a hugely popular endeavor.

The carry trade era (2000-2024)

The term was popularized in the early 2000s when the strategy became very popular due to the lowest interest rates by the central Japanese bank. The setup was very simple: borrow JPY at near-zero interest rates, invest in AUD bonds (5%+) or the U.S. stock markets. The outcome was a generated profit of 7-12% annually until 2024 when BoJ rate hikes caused a 13% USD/JPY crash. At its peak, yen carry trades comprised 20% of daily FX turnover, which is substantial.

2024 Unwind case study

In 2024, the Japanese central bank made a controversial decision to change the rates from below zero to 0.25%. While it may seem like a minor increase, this caused a serious crash and made carry trade strategies almost unprofitable due to the rapid exchange rate decline for the USD/JPY. AUD/JPY also fell 8% in a week, liquidating 12 billion dollars in positions. This only indicates both the potential and risks of carry trades. It all depends on the central bank policies and you do not want to see price crashes either. To avoid risks, traders need to know how to develop a viable carry trade method, which we will discuss below.

Executing a Forex Carry Trade Strategy

Carry trade Forex strategy is crucial for capitalizing on interest rate spreads while minimizing risks with predetermined parameters. Let’s outline a basic yet powerful step-by-step guide for the proper implementation of a Forex carry trade strategy.

Step 1. Currency Selection

This is the first and most important step. You need to look for low-yield currencies like JPY and CHF. The interest rates are typically lower for these currencies. The next step is to select and add to your watch list high-yield currencies like USD, MXN, AUD, etc. To check for interest rates, you use central bank rates data.

Step 2. Calculate swap rates

You can easily find swap rates on the dedicated page of swaps, which is offered by almost all reputable brokers. For example, if the USD has a 2.5% rate and CHF has -0.75% you can make money on long positions.

Step 3. Confirming trends

Before you enter a long or a short position ensure that the major trend agrees with your direction. The easiest way is to use a 200-period moving average. When the price is above the 200 exponential moving average then it is fine to enter long positions and vice versa for the price is below the 200 EMA.

Top carry trade charts

There are several currencies where money could be made as a result of interest rate differential. The most popular pairs include USD/CHF, USD/JPY, and GBP/JPY. AUD/JPY could also provide some minor opportunities. Just remember to always take into account the main trend in the pair you are going to trade. Forex carry trade charts should be analyzed just like any other asset class by using a standard technical analysis. You need to define the main trend and when the opportunity agrees with the main trend it enhances win rate and profitability.

Diversification techniques

The most appropriate approach when using carry trade charts is to use a basket approach. This is when you are long in the top 3 high-yield currencies and short in the top 3 lower-yield currencies.

It is crucial to have a diversified portfolio of carry trades to ensure you are exposed to fewer risks. Even if one carry trade does not work there are still others to make up for it. Leverage management is crucial when trying to diversify. In our carry trade strategy example, we showed that you always try to follow major trends, but it does not guarantee success and conservative leverage is a tool to mitigate risks.

Carry trade strategy risks and Solutions

Carry trade strategy risks include exchange rate volatility, liquidity black holes, interest rate reversals, and heightened volatility. Knowing when and how to mitigate those risks is critical to maintain profitability and protect your carry trade capital.

Main carry trade strategy risks

The first risk related to carrying trade betting is exchange rate volatility. This one cause accounts for around 80% of losses. The main example would be a 2024 yen surge when exchange rates were raised. Surprisingly, this would be relatively easy to anticipate and mitigate prior to the announcement as there were all the conditions and indications that BoJ was about to raise interest rates. Another challenge is liquidity black holes are more difficult to predict. This occurs during panics, as crowded exits cause price gaps. For example, the GBP/JPY fell 20% in 2008. Gaps are scary as they can easily cause the price to move past the stop-loss order, causing major losses.

Interest rate decisions when central banks increase rates also have a serious potential to erase spreads and make profitable pairs potentially lose money. This is why traders need to check central bank rates and know when new announcements are released. This can be checked using an economic calendar. Leverage should also be conservative as high leverages beyond 1:100 can make the strategy very risky and sensitive to minor price changes. 1:10 leverage, for example, can turn a 5% loss into a 50% loss and traders should be careful to wisely employ the power of leverage with proper stop loss and risk controls.

Hedging techniques for carry trade strategy risks

There are several popular techniques or rather instruments for hedging purposes. Hedging means taking on opposite trade in another asset to counter price fluctuation risks. Options are popular assets for hedging against carry trade strategy risks. By buying call options on funding currency (JPY calls for AUD/JPY shorts), traders can effectively counter risks and reduce the chances of loss. However, there is a cost for using options as a hedge and this cost should be 1-2% of gains. If it is higher then it is not feasible to employ options.

Traders should avoid trading when volatility is high or with correlated pairs. Stop-loss orders should also be used and the recommended percentage is 5-7% below entries.

When to avoid carry trades

There is a volatility index, VIX. When this index reading is above 30, you should avoid the Carry trade FX strategy as high volatility can cause major price swings, erasing profit potential quickly. Generally, highly volatile markets are dangerous for traders, especially for beginners, who do not have strong trading skills yet.

Another time to avoid carry trade strategies is when the interest rate differential becomes negative, meaning the target currency yields less than the funding one.

Beyond Forex - Advanced carry trade strategies

Carry trade FX strategy can be a powerful tool for profits but there are other methods developed as well. Other strategies include volatility carry, commodity carry, and multi-asset portfolios. The volatility carry (VIX) tries to capitalize on short front-month VIX futures, rolled monthly. This strategy is uncorrelated to carry trade FX strategy and involves futures. Commodity carry trades have the following concept: buy backwardated (the price of the underlying asset is higher than its futures price) assets like futures priced below the spot and sell contangoed (assets cheaper on the spot market than futures) ones.

Multi-asset portfolios are also viable where traders combine Forex, volatility, and commodity carry trades to form a portfolio that is well-diversified, and protected from adverse market movements.

Conclusion

Overall, the carry trade FX strategy offers a unique path to profit from interest rate gaps in the markets - borrow cheap (JPY, CHF), and invest high (USD, MXN). However, its simplicity masks complex risks. While history shows that carry trade can be very profitable, we also have examples when whole year’s profits got erased in a day. For decades, traders like Japan’s “Mrs. Watanable” generated profits from yen-funded bets on AUD or USD assets for a steady 5-12%. Yet the 2024 BoJ interest rate hike shock made the strategy risky. Traders should try to carry trade positions in the direction of major trends, hedge against risks, and diversify their trades to ensure stable earnings even when markets get volatile and VIX is above 30. Modern traders diversify their carry trades beyond Forex and often employ futures and commodities to ensure higher win rates.