What is carry trade in international finance?

• A. Borrowing in a currency with a low interest rate and investing in a currency with a higher rate, exposing to exchange-rate risk.
• B. Investing in high-yield assets domestically.
• C. Hedging currency exposures to reduce risk.
• D. Avoiding currency risk by matching maturities.

Answer: (A)

Carry trade is the practice of borrowing in a currency with a low interest rate and investing in a currency or assets that offer a higher yield. The appeal comes from pocketing the interest-rate differential, which can boost returns, especially when leverage is used. But the catch is currency risk: if the funding currency (the one you borrowed) strengthens against the investment currency, the cost to repay the loan rises and can erode or wipe out the interest gains. Conversely, if the funding currency weakens, profits can grow. This approach relies on the differential and the expectation that exchange rates will stay favorable or move in your favor, which is why timing and risk management are crucial. It’s not simply about investing domestically in higher-yield assets, nor is it about hedging away all currency risk or perfectly matching maturities to avoid FX exposure—the core idea is exploiting the interest rate spread across currencies, with FX risk as the key concern.