The term carry trade simply refers to a strategy in which investors sell low-yielding currencies and buy high-yielding ones. This allows investors to earn an interest rate differential by simply holding, or carrying a currency position. It is this interest rate differential that is reflected in the Swap Points and is paid to or paid by the investor on a daily basis. It gains popularity in times of currency stability and when significant discrepancies between countries interest rates exist.

This is the case currently (July '07) with the Japanese Yen where the interest rate target set by the Bank of Japan is just 0.5% versus New Zealand 8.0%, Australia 6.25%, UK 5.75% and US 5.25%. If an investor holds a short Yen position against any of the above currencies they will be paid the swap points on a daily basis. And with leverage available the earnings from these swap points can be significant. On the other hand if the investor holds a long position in Yen they will have to pay the swap points on a daily basis.

The risk of carry trades is that foreign exchange rates will change, and the investor will have to pay back now more expensive currency with less valuable currency. In theory, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate one, i.e. the exchange rate should adjust for the interest rate differential. However, carry trades weaken the target currency, because investors are selling it to buy other currencies, and therefore the more popularity a particular carry trade gains the better it works. As of early 2007, it is estimated that as much as US$1 trillion may be staked on the Yen carry trade.

Client A buys 200,000 (2 lots) New Zealand Dollars (NZD) and sells Japanese Yen (JPY) at a rate of 95.50 giving them a long 200,000 NZD/JPY position at 95.50.

The swap points based on the interest rate differential for NZD/JPY are -2.02/1.97 (if long NZD/JPY you receive 1.97 points, if short NZD/JPY you pay 2.02 points) In this case Client A will receive 1.97 points or 1,970 Yen per lot each day the position is maintained (carried). 1,970 x 2 lots = 3,940/day

Client A has carried the position for 10 days and will earn 39,400 Yen from the swap points alone.
1,970 x 2 lots x 10 days = 39,400 Yen

Client A entered into a long position at 95.50 and unwinds (sells) the position at 95.80 earning a trading profit of 60,000 Yen. 2 lots x 30pips (95.80-95.50) x 1000 Yen/pip = 60,000 Yen.

Total profit on this trade is 39,400 + 60,000 = 99,400 Yen

Client B has carried the position for 10 days and will earn 39,400 Yen from the swap points alone.
1,970 x 2 lots x 10 days = 39,400 Yen

Client B entered into a long position at 95.50 and unwinds (sells) the position at 95.20 creating a trading loss of
-60,000 Yen. 2 lots x -30pips (95.20-95.50) x 1000 Yen/pip = -60,000 Yen.

Total loss on this trade is 39,400 - 60,000 = -20,600 Yen

In a traditional carry trade a trader borrows 100,000 yen from a bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. This system is simplified and allows for the use of greater leverage when trading currencies on margin.