Carry Trade, Definition

The carry trade strategy is based on buying a high interest yielding currency and selling a low yielding currency. This allows the trader to earn the difference in the interest rates between the two currencies, referred to as the interest rate differential.

The differences between interest rates of countries is what creates this opportunity. Countries who are experiencing economic growth will offer higher rates of interest. However, with the higher interest rates comes risk - there is no guarantee that the country's economy will be able to pay the interest on it's currency.

For example if the Japanese Yen offers an interest rate of 0.25% and the New Zealand dollar offers an interest rate of 6.25%, some one selling the Yen and buying the New Zealand dollar can earn a profit of 6% as long as the exchange rate between the New Zealand dollar and yen remain unchanged.

Some speculators hedge the exchange rate exposure - aiming only to capture the interest rate differential. This return can be increased through leverage. The Yen and the Swiss Franc have been the main funding currencies due to their low interest rates.