Carry Trade Defined, or Why Interest Rates Matter

Here’s what sounds like a surefire way to improve an asset’s returns: Use cheaper money to buy it. That’s the core of what’s known as a foreign-currency carry trade. Investors take advantage of a difference in interest rates between two countries to borrow where the rate is low and invest where it’s high. In early 2022, the focus shifted to borrowing in U.S. dollars or the euro to invest in Latin American currencies where rates in countries like Brazil, Chile and Colombia are climbing -- in stark contrast to the U.S. and Europe, where borrowing costs are still near zero. But be warned. Carry trades can also be a good way to lose large sums, given that exchange rates are prone to unpredictable corrections. And the current enthusiasm may be dampened by the prospect that the Federal Reserve will soon push U.S. rates up.

In finance speak, the “carry” of an asset is the return obtained from holding it. So a carry trade involves buying a currency and “carrying” it until you make a profit.