Borrowing in a low-interest-rate currency to buy a high-interest-rate one, earning the rate difference as long as the exchange rate cooperates.
The carry is collected daily through the swap-rate. It works in calm markets and unwinds violently in risk-on-risk-off shocks, when everyone rushes to close the same positions at once.
The yen has been the classic funding currency; when it strengthens fast, carry trades get liquidated and the move feeds on itself.
Example: borrowing yen at 0.1% to hold Mexican pesos at 10% earns about 9.9% a year in carry. A 10% rise in the yen against the peso erases a year of carry in days.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Contango and backwardation. A futures curve shows what buyers will pay for delivery in one month, two months and so on. When later contracts cost more than the spot price the curve is in contango; when they cost less it is in backwardation.
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