Carry trade

A carry trade is built from two legs: borrowing (or shorting) a currency with a low policy rate, historically the Japanese yen has been a common funding currency, and using the proceeds to buy (or go long) a currency with a meaningfully higher rate. The trade earns the interest rate differential between the two, often called the carry, for every day the position is held, on top of, or against, whatever the spot exchange rate does over the same period.

The trade is attractive when the rate differential is wide and expected to stay wide, and when the funding currency is expected to stay stable or weaken further, since a stable or falling funding currency means the borrowed leg costs less to eventually repay. Carry trades tend to cluster and unwind together across many traders at once, since they're all responding to the same rate environment, which is part of why a shift in the funding currency's own policy expectations can trigger a fast, correlated unwind across the whole trade.

Carry trades carry a specific, well-documented failure mode: a sudden strengthening of the funding currency, often during a broader risk-off shock, can wipe out months or years of accumulated interest-rate profit in a matter of days, since the currency loss on the funding leg dwarfs the daily carry earned. This has happened abruptly enough, and to a large enough share of the market at once, to move broader asset prices when it unwinds. The trade also assumes the rate differential itself holds, but central banks change policy, and a narrowing differential erodes the whole rationale for the position even before any exchange-rate move happens.

Suppose a trader borrows yen at a policy rate near 0.5% and uses the proceeds to buy Australian dollars yielding 4.35%, pocketing roughly a 3.85 percentage point annualized carry if the exchange rate holds steady. If AUDJPY drifts sideways or grinds slowly higher over the following months, that carry accumulates as steady profit. But if a risk-off shock sends capital rushing back into yen, and AUDJPY drops 8% in a matter of weeks, that single move wipes out more than two years of the trade's accumulated carry in one stretch, which is exactly the asymmetry that makes carry trades look steady for long periods and then fail abruptly.