When you do a carry trade, a strategy where you borrow money in a low-interest currency and invest it in a higher-yielding one. Also known as interest rate arbitrage, it sounds like free money—until the market turns. You’re not just earning interest. You’re betting that the currency you bought won’t crash against the one you borrowed. And that’s where things get dangerous.
The biggest currency risk, the chance that the value of your invested currency drops sharply against your funding currency can erase months of gains in days. In 2022, the Japanese yen dropped over 20% against the US dollar in just six months. Traders who borrowed yen to buy Australian dollars or Turkish lira saw their profits vanish—and then some. Then there’s leverage in forex, using borrowed capital to amplify returns, which also amplifies losses. Many retail traders use 10:1 or 20:1 leverage on carry trades. One bad move and you’re wiped out. Even banks got burned in 2008 when the global funding market froze. The funding currency, the low-yield currency you borrow, often the yen or Swiss franc can suddenly become expensive to borrow when markets panic. That’s when carry trades unravel fast.
Interest rate changes don’t happen in a vacuum. Central banks don’t just raise rates because they feel like it. They react to inflation, growth, and global capital flows. If the Fed hikes rates while the Bank of Japan keeps rates near zero, the carry trade looks great—until the Fed starts cutting and the yen strengthens again. That’s the trap: you think you’re locking in yield, but you’re really betting on the timing of central bank moves you can’t control.
There’s no magic formula to avoid these risks. But knowing what to watch for helps. Track central bank statements. Watch volatility indexes in the currencies you’re trading. And never, ever use high leverage without a clear exit plan. The posts below break down real examples—from the 2008 crisis to recent yen trades—showing how carry trades succeed, fail, and sometimes explode. You’ll see what traders actually did right, what they ignored, and how to protect your capital when the tide turns.
