I am trying to understand the classic carry trade. I would greatly appreciate any help. My questions might not be the simplest, but hopefully I have posted this in the right subforum (Economics). There are perhaps many currency pairs that you can do the carry trade, but let us take the US dollar against the Japanese yen (USDJPY). From Investopedia https://www.investopedia.com/articles/forex/09/credit-crisis-carry-trade.asp: Borrow 100 million yen for one year at 0.50% per annum. Sell the borrowed amount and buy U.S. dollars at an exchange rate of 115 yen per dollar. Use this amount (approximately US$870,000) as 10% margin to acquire a portfolio of mortgage bonds paying 15%. The size of the mortgage bond portfolio is therefore $8.7 million (i.e. $870,000 is used as 10% margin, and the remaining 90%, or $7.83 million, is borrowed at 5%). ------------------------------------------------------------------------------------------------- After you do all this there are basically 2 scenarios that investopedia analyses, the good times and the bust scenario. While I have understood this example of a carry trade, there has been no mention of interest rate differential at all, and my questions arise because Bloomberg and other sources always tout about how this specific pair (USDJPY) is led by the difference in the interest rates. 1st question) If we assume that a higher fed funds rate leads to somewhat higher deposit or savings rates, is it correct to assume that if the US raise rates USDJPY will increase in value because there are many people who will borrow yen to buy dollars and deposit them in US bank savings or CD accounts? 2nd question) Even if my first assumption is right, then my second perhaps equally important question is why do longer term interest rates also play a role in the direction of USDJPY? The 10 year US yield as an example that is now at 2.4%. If it falls to 2% as an example, everyone will assume that USDJPY will probably drop, but I can't see the correlation with this and the carry trade. Can anyone explain?

The base interest rate differential is "embedded" in the differential between the rate at which you've borrowed yen (0.5%) and lent dollars (15%). 1) All else being equal, yes... 2) While you're correct in being somewhat puzzled by this effect, you need to consider that a carry trade you've described can actually have different time horizons. For instance, why couldn't an investor borrow yen at a fixed rate for 10 years, convert the proceeds into dollars, buy 10y treasuries and put the resulting "trade" away for the whole 10y term? This implies that the rate differential relevant to the discussion of the "carry trade" depends on the time horizon of the marginal mkt participant involved. This, generally, would depend on a whole variety of factors. There are a few additional complexities of this sort as well. While there are no hard and fast rules, you can probably pick some forward rate between 2 and 5yrs as your "carry" inputs.

A currency trader named Larry Liked to collect lots of carry. He shorted some yen And was recently canned, But found a new job in a hurry