The term carry trade without further modification refers to currency carry trade: investors borrow low-yielding currencies and lend high-yielding ones. It tends to correlate with global financial and exchange rate stability, and retracts in use during global liquidity shortages.[2]
The risk of carry trades is that foreign exchange rates will change, and the investor will have to pay back now more expensive currency with less valuable currency.[3] In theory, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate one. However, carry trades weaken the target currency, because investors sell what they have borrowed, and convert it into other currencies.
For example, a trader borrows 1,000 yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Assuming the bond pays 4.5% and the Japanese interest rate is set at 0%,[4] the trader stands to make a profit of 4.5% (i.e. 4.5% - 0%), as long as the exchange rate between the countries does not change. Leverage can make this type of trade very profitable. If the trader above uses a leverage factor of 10:1, then he/she can stand to make a profit of 45% (i.e. 4.5% * 10). However, if the U.S. dollar were to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Furthermore, because of the leverage, small movements in exchange rates can magnify these losses immensely unless hedged appropriately.
As of early 2007, it is estimated that as much as US$1 trillion may be staked on the yen carry trade.[5] Since the late-1980's, the Bank of Japan has set Japanese interest rates at extremely low levels making it profitable to borrow Japanese yen to fund activities in other currencies.
