The carry trade exploits the interest rate differential between two currencies. You borrow in the low-yield currency (funding currency, e.g. JPY or CHF historically at 0%) to invest in a high-yield currency (target currency, e.g. AUD, NZD, MXN, TRY).
Profit comes from two sources:
- Rate differential (the carry): you earn daily interest on the high-yield currency, paid via your broker's overnight swap
- Favorable FX move: if the high-yield currency appreciates, additional gain
Historical examples: the 2000-2007 decade saw massive JPY → AUD/NZD/USD carry trades with 4-5% rate spreads. The 2008 crisis violently unwound these positions (yen +30% in 6 months), wiping out carriers.
Risks: very low in calm periods, huge in market stress. When volatility spikes, carry trades are the first to liquidate ("carry unwind") → violent moves against the carry direction. Only suitable for long-term capital without high leverage.