An investment strategy whereby the investor borrows from a low-yielding or low-interest currency, and invest in high-yielding or high-interest currency.
Carry trade is a term mostly used in the currency market. The idea behind carry trade is to buy a currency that offers high interest rates, while selling one that offers low interest rates. Then, by holding the position, the trader gains the differential.
For example GBP/JPY is a popular pair for carry trade. When going long this pair, the trader is essentially borrowing Yen to purchase Pound. Since the UK has a higher interest rate then Japan, the trader is earning rollover interest as indicated on the right on the "IntBuy" collumn of the Dealing Rates Window.*
The risk is in the changing value of the currencies because a trader has to hold a position in order to receive the interest rollover. However, the exchange rate fluctuation sometimes outweigh the interest earned.
Here's an example of a "yen carry trade": a trader borrows 1,000 Japanese yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.
The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, 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. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.
A currency carry trade — A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.