An investment strategy of borrowing funds in a market with low interest rates and investing in debt securities or other assets in a different market. For example, an investor might borrow money in a country in which interest rates are low and invest the borrowed funds in a different country in which interest rates are high. Likewise, an investor could borrow at low short-term rates and invest the funds at higher long-term rates. Changes in relative interest rates or economic conditions can result in this strategy producing substantial losses.Case Study
Large flows of money in the carry trade can move interest rates, investment values, and currency exchange rates. Years of weak economic growth caused Japan's central bank to maintain a short-term benchmark interest rate of zero. The carry trade took advantage of the low rates by borrowing funds in Japan, converting yen to dollars, euros, and other currencies, and investing in the United States, Europe, and other countries with higher interest rates or promising investment opportunities. For example, a large investor such as a hedge fund might borrow in Japan, convert yen to dollars, and invest in high-yielding bonds in the United States. The flow of cash out of Japan caused the yen to decline versus the dollar and other currencies, until in early 2007 the yen had hit an all-time low versus the euro and was generally considered the world's weakest major currency. In early 2005, 100 yen were worth approximately $0.98 U.S. dollars, while two years later the same 100 yen were worth only about $0.82. The falling value of the yen resulted in even greater profits for the carry trade, because the currencies into which yen had been converted were worth even more yen when the trades were eventually reversed. Investors became worried about overvalued stock markets and real estate values by spring 2007 and started converting dollars back into yen, thereby causing the dollar to decline in value versus the yen.