A carry trade involves borrowing in a currency with a low interest rate (the funding currency) and investing in one with a higher rate (the target currency). The trader pockets the difference in interest — the 'carry' — for as long as the position is held and the exchange rate cooperates.
For years the Japanese yen was the classic funding currency because Japanese rates sat near zero, while higher-yielding currencies served as targets. The popularity of yen-funded carry is a major reason the yen is so sensitive to global risk sentiment.
Why it works — until it doesn't
In calm, trending markets, carry trades can deliver steady returns: you earn the differential, and the higher-yielding currency often appreciates too. But the strategy has a sharp tail risk. When volatility spikes and risk appetite collapses, crowded carry positions unwind quickly, driving the funding currency sharply higher and the target sharply lower.
This asymmetry — 'picking up pennies in front of a steamroller' — means carry trades demand careful sizing and an eye on volatility regimes, not just the headline interest-rate gap.