The Carry Trade is a trading strategy where investors/traders sell or borrow assets with lower-yielding interest rates to fund or buy higher-yielding assets.
In forex, carry trade involves borrowing in currencies with low-interest rates (called funding currencies) and investing in those with high-interest rates (the target currencies)
Examples of recently attractive target currencies are the Brazilian
real, the South African rand and the Australian dollar.
Popular funding currencies included most recently the U.S. dollar and historically also the Japanese yen or the Swiss franc.
If the target currency does not depreciate vis-à-vis the funding currency during the life of the investment, then the investor earns at least the interest differential.
This strategy does not work if uncovered interest parity (UIP) holds.
The UIP condition states that higher-yielding currencies will tend to depreciate against lower-yielding ones at a rate equal to the interest differential so that expected returns are equalized in a given currency.
Under UIP, any interest differential is expected to be fully offset by currency movements.
A large body of empirical literature documents that UIP fails almost
universally at short- and medium-term horizons.
In many cases, the relationship is precisely the opposite
of that predicted by UIP: currencies with high-interest rates tend to appreciate while those with low-interest rates depreciate.
This failure of UIP is so well established that the phenomenon is called the “forward premium puzzle”.
The failure of UIP is no secret to investors, hence the popularity of carry trades.
The carry trade puts upward pricing pressure on target currencies and downward pressure on funding currencies.
This could result in the amplification of the underlying exchange rate
In addition, it may also result in more rapid exchange rate moves when carry trade investors unwind their positions.
A popular carry trade has been to sell Japanese yen and buy higher yielding currencies such as the Australian dollar and New Zealand dollar.
For example, if you buy the AUD/JPY, then you sell Japanese Yen (which yields 0.00% a year)and buy an equivalent amount of Australian Dollars (which yields 3.50% a year) simultaneously.
As long as you hold that position you would pay 0.00% interest a year for borrowing Japanese yen, and receive 3.50% a year for holding Australian dollars.
The interest rate differential of that position is +3.50 (3.50% – 0.00%).
So you would receive approximately 3.50% a year on the value of the position, depending on the margin interest charged by the broker and on exchange rate volatility.