Currency Carry Trade is a trading strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used. However the risk is that exchange rates change during the period the carry trade is held, which could be much more than the interest earned.
For example: NZD/JPY (New Zealand Dollar/Japanese Yen) has been a popular carry trade. NZD is the currency with the higher yield and JPY is the currency with the lower yield. Traders looking to take advantage of this interest rate differential would buy NZD and sell JPY, or be long NZD/JPY.
Depending on the leverage used the interest earned from a carry trade can be substantial over time.
The currency with the lower interest rate is often called the "funding currency". Which is the currency that investors want to borrow. And the currency with the higher yield is the "asset currency".
The carry trade is one of the most popular strategies in currency market. The best time to get in the market is when central banks are contemplating raising interest rates in the "asset currency" and thus widening the interest rate spread.
This strategy does not hedge out the currency risk. A big problem with this strategy is that changes in the price of the currency pair quickly can create losses that are bigger than the interest earned.