Carry Trade in Forex: How It Works and Key Risks

Topic Summary

A forex carry trade involves selling a currency with a lower interest rate and buying one with a higher rate.

Traders follow these setups because interest rate differences, policy cycles, and volatility can influence how well they hold up over time.

• A carry trade uses the interest rate gap between two currencies, but the exchange rate still drives most of the outcome.
• These trades hold up better when volatility is low, and central bank policies move in different directions.
• Policy changes, rising volatility, and leverage can quickly increase risk and reduce the appeal of a carry setup.
• Traders screen for clear rate gaps, stable conditions, and simple technical signals before holding positions overnight.

Carry trades are among the most widely discussed concepts in the forex market because they connect interest rate policy with currency movements.

The idea is simple, but the real work comes from understanding when the environment supports these trades and how to manage the risk once a position is open.

By learning how rate cycles, volatility, and market sentiment shape carry performance, you can build a clearer view of when the strategy is practical and when it becomes more vulnerable.

What Is a Carry Trade in Forex?

A carry trade is a strategy in which you sell a currency with a lower interest rate and buy one with a higher interest rate.

The goal is to benefit from the interest rate differential while also managing the impact of any price movements between the two currencies.

Traders engage in carry trades because interest rate gaps shift over time as central banks adjust their policies.

When you trade carry setups through CFDs, you are speculating on price movement and the daily swap adjustment rather than owning the currencies directly.

Swap charges or credits apply when the position is held overnight, reflecting the interest rate differential between the two currencies.

Traders can view these financing details for each forex pair on the PU Prime platform before opening a position.

→ If you want to understand how leverage and overnight financing interact in forex CFDs, you can read PU Prime’s guide.

How a Forex Carry Trade Works

A carry trade combines interest rate differences with changes in the exchange rate.

Traders choose one currency to fund the position and another currency to target, then hold the position to gain exposure to both components of the trade.

Choosing the Funding Currency and the Target Currency

Funding currencies usually have low interest rates.

Target currencies offer higher rates.

The difference between the two sets determines the carry.

Traders look at current interest rate settings and central bank expectations to understand which currencies sit on each side.

Holding the Position Overnight

When a carry trade is held overnight, the position receives or pays a swap based on the rate difference.

A positive differential may generate a credit.

A negative differential creates a charge.

These adjustments occur daily, thereby influencing the overall cost of holding the trade.

Two Drivers of Outcome

The result of a carry trade comes from two sources.

First, the interest rate gap shapes the ongoing swap credit or charge.

Second, any change in the exchange rate adds or subtracts from the position’s value.

Traders track both elements because price movement can outweigh the interest rate benefit.

Examples of Classic Carry Pairs

Pairs like AUDJPY and NZDJPY have historically been used when rate differentials supported them.

These examples shift over time because central banks change policy in response to economic conditions.

Traders review current rate settings rather than relying on past patterns.

Core Risks of Carry Trading

Carry trades involve several risks that can change the outcome of the position.

These risks come from price movement, central bank decisions, market volatility, and the effects of leverage.

Understanding them helps you judge whether a carry setup is stable enough to hold.

Exchange Rate Risk

The currency pair can move against your position.

A negative move in the exchange rate can outweigh the benefit of the interest rate gap, especially during periods of uncertainty or weak market sentiment.

Interest Rate Risk

Central banks can update their policy rates with little warning. A rate cut in the higher-yield currency or a

rate increase in the lower-yield currency can reduce or remove the positive differential that supports the carry.

Volatility and Carry Crash Risk

Carry trades tend to struggle when volatility rises.

Sudden shifts toward risk-off behaviour can prompt traders to unwind high-yield positions, resulting in sharp price swings.

These periods have historically produced large drawdowns for carry strategies.

Leverage Risk in CFDs

CFDs allow traders to use leverage, which can amplify both gains and losses.

Significant market moves, price gaps, or unexpected volatility can increase risk when holding positions overnight.

Traders stay aware of their margin level and monitor exposure during major announcements.

Why Market Regimes Influence Carry Trades

Carry trades tend to behave differently depending on the broader market environment.

Periods of stability can support these setups, while periods of stress can create sharp reversals.

Traders watch these shifts to judge whether carry exposure is practical or more vulnerable.

Market Conditions That Support Carry Trades

Carry trades often hold up better when volatility is low, price action is stable, and central bank policies move in different directions.

These conditions can help the interest rate gap play a larger role in the overall result.

Conditions That Pressure Carry Trades

Risk-off periods, sudden volatility spikes, or signs of financial stress can lead traders to rotate out of higher-yielding currencies.

This can cause fast price swings that challenge carry positions and reduce the influence of the rate gap.

Gauging Sentiment

Traders use indicators such as volatility indexes, global equity trends, and broader risk sentiment to assess whether the environment supports carry exposure.

These signals help traders decide when conditions are more stable and when caution is needed.

Reading Interest Rate and Policy Backdrop

Interest rate settings underpin every carry trade.

Traders watch both current rates and expected policy changes to understand which currencies offer higher yields and how long those differences may last.

Current Policy Rates

The first step is reviewing the official rates set by central banks.

These rates determine which currencies sit on the high-yield side and which sit on the low-yield side.

Traders compare these rates to see where positive differentials exist.

Forward Guidance and Policy Signals

Central banks often signal the direction of future policy through speeches, statements, and meeting minutes.

A shift toward a more hawkish or dovish stance can change the appeal of a carry trade by altering expected rate gaps.

Why These Shifts Influence Carry Trades

Changes in policy expectations can increase or reduce the advantage of holding a currency with a higher yield.

When rate expectations adjust quickly, the currency pair can move sharply, and the positive differential may shrink or reverse.

Traders closely track these developments to gauge whether the carry setup remains stable.

Step-by-Step Screening for Carry Trade Setups

A structured workflow helps traders identify carry trade opportunities that align with current market conditions.

The steps below outline a simple way to screen for potential setups.

1. Identify Rate Differentials

Start by checking which currencies offer higher interest rates and which ones sit at the lower end.

High-yield currencies may benefit carry trades, while low-yield currencies often serve as funding currencies.

Traders focus on pairs where the interest rate gap works in the desired direction.

2. Check Volatility and Risk Sentiment

Carry trades tend to perform better in low-volatility environments.

Traders look at volatility indexes, global equity trends, and general sentiment to judge whether the market is stable enough for a carry setup.

Rising volatility can create challenges for this strategy.

3. Shortlist Candidate Pairs

After identifying the rate gaps and market conditions, traders shortlist pairs that show a positive differential and relatively stable or trending price action.

The goal is to find currency pairs where both the rate gap and the market environment support the trade’s direction.

Example Screening Table 

High-yield currencies	Low-yield currencies	Example pair	Rate insight*
AUD	JPY	AUDJPY	AUD often has higher rates than JPY when policy diverges.
NZD	CHF	NZDCHF	NZD has historically offered higher yields than CHF.
MXN	JPY	MXNJPY	TRY often trades at very high rates but with elevated volatility.
ZAR	EUR	ZAREUR	ZAR yields can exceed eurozone rates during tightening phases.
TRY	JPY	TRYJPY	TRY often carries very high rates, but with elevated volatility.

*These examples are for illustration only. Actual opportunities change as central banks update policy and economic conditions evolve.

Using Technical Analysis to Time Entries and Exits

Technical analysis helps traders find clearer entry and exit points when working with carry trades.

Since carry positions often run for more extended periods, timing can influence both the swap component and the impact of price movement.

Trend Structure

Traders often prefer carry trades that move in the same direction as the interest rate advantage.

A clear uptrend or downtrend can help reduce the risk of holding a position that moves against the carry.

Trend structure gives context to whether the market supports the position.

Pullbacks and Breakouts

Some traders look for pullbacks into support within an existing trend as potential entry areas.

Others wait for breakouts in the direction of the carry to confirm momentum.

The goal is to align the entry timing with a stable price environment.

Stop Placement Considerations

Carry trades usually run longer than intraday setups, so traders often think about wider stop placement.

Stops may be set beyond key technical levels such as recent swing highs or lows.

This helps account for normal fluctuations while keeping risk parameters clear.

Position Sizing and Portfolio-Level Risk

Carry trades can stay open for extended periods, which means position size and portfolio exposure play a key role in overall risk control.

A clear structure helps traders avoid outsized losses during periods of volatility or policy changes.

Account-Level Risk Limits

Many traders set a maximum percentage of their account equity per position.

This helps prevent a single trade from dominating overall exposure.

Carry trades can accumulate swap credits or charges over time, so understanding the total position size is essential.

Avoiding Concentration Risk

Some currency pairs behave similarly because they respond to the same interest rate or risk conditions.

Holding several trades that share the same underlying theme can increase exposure without providing meaningful diversification.

Traders monitor the overlap between positions to avoid concentration in one direction.

Correlation Awareness

Currencies often move in clusters.

For example, several high-yield or low-yield currencies can respond in the same way to shifts in sentiment.

Traders review correlations to understand whether their portfolio has multiple trades tied to the same outcome.

This helps keep the overall risk profile balanced.

Managing Tail Risk and Exits

Carry trades can be sensitive to sudden market shifts, so traders use clear exit plans to manage unexpected moves.

Having predefined rules helps limit losses when volatility rises or market sentiment changes.

Predefined Exit Rules

Some traders set exit conditions based on price levels, volatility thresholds, or scheduled economic events.

These rules help remove emotion from the decision and provide structure when markets move quickly.

Clear exit points also help control the impact of large swings that can occur during risk-off periods.

Responding to Volatility Spikes

Sharp increases in volatility can create pressure on high-yield currencies. Traders monitor volatility indexes and major news events to judge whether conditions are becoming unstable. A sudden spike can signal a time to scale back exposure or close positions early.

Hedging Concepts

Some advanced traders manage extreme risk by using hedging tools such as options, where available.

This can help reduce exposure to sharp downside moves, although it adds cost and complexity.

Hedging is one way to limit the impact of unexpected events, but it requires a clear understanding of how each tool works.

How Carry Trades Can Fit Into a Trading Plan

Carry trades can play a specific role within a broader forex approach.

They rely on interest rate differences, stable conditions, and longer holding periods, which makes them different from short-term strategies.

When used with clear expectations, they can complement other trading methods.

Strategy Role

Carry trades are often used as medium to longer-term positions.

They rely on steady conditions rather than fast swings.

Traders approach them with the understanding that both swap adjustments and price movement shape the outcome.

Diversification Within the Forex Approach

A carry trade can sit alongside momentum, breakout, or range strategies.

Each method responds to different types of market movement.

Using multiple approaches can help balance risk by not relying on the same signals or conditions.

Aligning With Goals and Risk Tolerance

Carry trades require patience and an ability to hold through normal fluctuations.

Traders consider whether this style aligns with their time horizon, preferred level of activity, and risk tolerance.

A precise match between strategy and personal goals helps set expectations for how the trade will behave.

Time Horizon and Monitoring

Carry trades often remain open for more extended periods, which means traders monitor both market conditions and account exposure throughout the life of the position.

Understanding the time horizon helps set expectations for how the trade may behave as rates and sentiment shift.

Typical Holding Periods

Carry trades can run from several days to multiple months, depending on market stability and the strength of the rate differential.

Longer holding periods increase exposure to both positive and negative swap adjustments and price changes.

What Traders Monitor

Traders keep an eye on policy announcements, inflation releases, employment data, and central bank updates.

They also track volatility and global sentiment to judge whether the environment continues to support the position.

Margin levels and overnight exposure are monitored as part of routine risk control.

The Bottom Line

A carry trade is built on the idea of selling a low-yield currency and buying a higher-yield one.

The strategy can work in stable conditions, but it requires careful attention to policy trends, volatility, and market sentiment.

Screening for apparent rate gaps, timing entries with simple technical tools, and managing both position size and exit rules help create a structured approach.

Carry trades are not guaranteed income strategies and can face significant losses when conditions shift, so ongoing monitoring and disciplined risk control remain essential.

Explore with PU Prime

If you want to review current swap charges, contract details, and available forex pairs, explore PU Prime’s different accounts.

Depending on your chosen account type, you’ll find information on live pricing, charting tools, and access to major and minor currency pairs, so you can assess how carry conditions are developing. 

FAQs

Are carry trades always profitable?

No. Carry trades can lose value if the exchange rate moves against the position or if central banks adjust policy to reduce the interest rate gap.

Which forex pairs are commonly used for carry trades?

Pairs with apparent rate differences, such as AUDJPY or NZDJPY, have been used historically.

Current opportunities depend on the central bank policy at the time.

When do carry trades usually perform poorly?

Carry trades can struggle during periods of high volatility or risk-off sentiment.

These conditions can create sharp reversals in high-yielding currencies.

How long do traders typically hold carry trades?

Holding periods vary, but carry trades often run for several days to several months.

The time horizon depends on market stability and rate expectations.

How do swap rates work in forex CFDs?

Swap rates reflect the interest rate difference between the two currencies in a pair.

Traders may receive a credit or pay a charge when positions are held overnight.

What risks should new traders focus on first?

Exchange rate risk, volatility spikes, and policy changes are the most immediate risks. Leverage can increase exposure to all three, so traders closely monitor position size and margin.