Interest Rate Arbitrage Depth Guide: From Yen Carry Trade to Exchange Rate Risk, Master the Hottest Profit Secret in the Capital Market

Why Did Carry Trade Suddenly Become Popular?

Since the Federal Reserve began its aggressive rate hike cycle in 2022, global capital markets have been swept up in a “carry trade” craze. However, many people still have a vague understanding of this concept—some see it as arbitrage, others as pure interest income. In reality, carry trading is far more complex and riskier than these ideas suggest.

The core of this trend is simple: when there are significant differences in interest rate policies among countries, smart capital starts seeking opportunities. They borrow low-interest-rate currencies, invest in high-interest-rate currencies or assets, and profit from the interest rate differential. But the problem is, not all rate hikes lead to currency appreciation—they can even trigger black swan events.

The Essence of Carry Trade: Financial Transactions Using Interest Rate Differentials

Carry trade is straightforward in definition: it involves exploiting interest rate differences between financial products or currencies across countries to earn a spread. The most common example is borrowing Taiwanese dollars to invest in US dollars, or borrowing Japanese yen to invest in other countries’ currencies.

For example: early 2022, the borrowing rate at Taiwanese banks was about 2%, while US deposit rates reached 5%. If someone borrows 2 million TWD from a Taiwanese bank, exchanges it for USD, and deposits it in an American bank, they can earn a 3% interest differential—purely from interest rates, without involving exchange rate fluctuations.

This sounds very safe. After all, rate hikes are usually accompanied by currency appreciation—an increase in the dollar’s value means the dollar gets stronger, so it should appreciate. If the TWD/USD exchange rate moves from 1:29 to 1:32, then this $100,000 not only earns interest but also gains from the exchange rate movement. 2.9 million TWD → $100,000 → 3.26 million TWD—that’s a double win.

But reality often tells a different story.

The Biggest Trap of Carry Trade: Rate Hikes Do Not Equal Currency Appreciation

Argentina is a stark lesson. To address its debt crisis and currency collapse, the Argentine government aggressively raised interest rates in the second half of 2023, with rates approaching 100%. Imagine: depositing 100 pesos in a bank and ending the year with 200 pesos—how attractive is that?

But even promising nearly double returns did not prevent investors from selling off. After the policy announcement, the Argentine peso depreciated by 30% in a single day. All the interest rate gains evaporated instantly, and the currency was actually lost.

This case reveals a truth: the economic fundamentals behind rate hikes are the key determinants of exchange rates. If a country faces debt crises, credit collapse, or political instability, even high interest rates cannot save its currency.

Therefore, carry trading is not “safe arbitrage” but a high-risk directional investment. Many traders leverage to amplify profits, which exponentially increases the risk.

The Three Major Risks of Carry Trade

1. Exchange Rate Risk

This is the most direct risk. Borrowing TWD to invest in USD, if the USD/TWD exchange rate depreciates, the interest gains cannot offset the exchange loss.

2. Interest Rate Change Risk

Interest rate differentials are not fixed; they can narrow or even reverse into losses.

Taiwan’s life insurance industry has experienced this pain. In the 2000s, many insurers sold fixed-interest policies with 6%–8% returns, while Taiwan’s deposit rates were as high as 10%–13%. Insurers earned a spread of 2%–5%, living comfortably. But now, Taiwan’s deposit rates have fallen to 1%–2%, and those policies promising 6%–8% are long-term burdens, even threatening solvency.

Similar stories happen in real estate investments: landlords initially expected rental income > mortgage rates, ensuring profit from the spread. But later, rising mortgage rates, stagnant rents, or even rent reductions to attract tenants can turn the spread into a loss.

3. Liquidity Risk

In theory, losses can be cut by exiting positions quickly. But in the real world, it’s not that simple.

Some financial products have poor liquidity—you buy at 100, but when you want to sell, you might only get 80. Some products require high transaction fees to exit. Long-term contracts like insurance policies are even worse—only policyholders have the right to cancel, and insurers are passive holders.

Liquidity risk means that even if you realize a carry trade is unfavorable, you might not be able to exit in time.

How to Hedge Carry Trade Risks?

The most common hedging method is using inverse or hedging financial products to lock in risk.

A typical case: a Taiwanese factory receives an order for 1 million USD. At the current exchange rate (1:32.6), this order is worth 32.6 million TWD. But delivery might be a year later, and the factory cannot predict the exchange rate then. To eliminate uncertainty, they can buy a forward FX contract (SWAP) to lock in the rate. This way, they won’t suffer losses from USD appreciation or depreciation.

The cost is paying for this “insurance,” which cannot be directly offset by expected currency appreciation. In practice, companies usually only pay for such hedges when facing uncontrollable risks like long holidays, and otherwise opt for natural hedging—converting investments back to the original currency or paying off leverage.

The World’s Largest Carry Trade Ecosystem: Borrowing Yen for Interest Arbitrage

Why do carry traders love borrowing Japanese yen? The reasons are simple:

Japan is one of the few developed countries with political stability, currency stability, and extremely low interest rates. More importantly, JPY is super easy to borrow. The Bank of Japan encourages domestic consumption by incentivizing borrowing, maintaining a long-term zero or negative interest rate policy. Although Europe has also implemented zero rates, large-scale euro borrowing for speculation is rare. The reason JPY is the “king of carry currencies” is Japan’s government’s relaxed attitude.

Strategy One: Borrow Yen to Invest in High-Yield Currencies and Assets

International capital first moves into Japanese banks, using USD or domestic assets as collateral, borrowing low-interest yen (around 1%), then investing in high-yield countries like the US or Europe—buying currencies, bonds, or stocks. The dividend or interest income is used to pay back the yen loan, with surplus used to prepay or expand investments.

Because borrowing costs are so low, even if exchange rates move slightly against, the overall trade remains profitable. This pattern has shaped the global capital market trend of “yen depreciation, other currencies appreciation” for decades.

Strategy Two: Borrow Yen to Invest in Japanese Stocks—Berkshire Hathaway’s textbook case

After the pandemic, with global quantitative easing, Buffett believed US stocks were overvalued and turned his focus to Japan. He issued Berkshire bonds, borrowed yen, and used the proceeds to buy Japanese blue-chip stocks.

He then took aggressive actions: demanding listed companies increase dividends or buy back shares, pressuring the Tokyo Stock Exchange, requiring higher liquidity, reducing cross-shareholdings, and insisting stock prices stay above net asset value or face delisting.

Within two years, Buffett’s Japanese stock investments gained over 50%. The smartest part: he had no exchange rate risk because he borrowed yen and invested in Japanese stocks—his returns came from Japanese corporate profits and dividends, not currency fluctuations.

For ordinary investors, borrowing to speculate on stocks sounds risky. But for someone like Buffett, who can directly influence corporate decisions, as long as the companies keep earning profits, the risk is actually quite low. This illustrates the difference between capital and influence.

Carry Trade vs Arbitrage: Two Concepts Often Confused

Many confuse carry trade with arbitrage, but their essence is entirely different.

Arbitrage usually refers to risk-free arbitrage: when the same product’s prices differ across exchanges or markets, traders exploit timing, information, or regional differences to buy low and sell high. As long as the price gap exists, they can lock in riskless profit.

Carry trade involves directly investing in assets with interest rate differentials, with traders actively bearing risks. Exchange rates may move, interest rates may change, liquidity may dry up. It’s impossible to eliminate risk—only to manage it.

The former is about “finding mispricings for instant profit,” the latter about “holding assets long-term to earn interest.” Their risk levels are completely different.

Keys to Success in Carry Trade

First, precisely control the holding period. You must set in advance how long the investment will last to choose suitable assets. Short-term arbitrage and long-term holdings require different products.

Second, analyze the regularity of price movements. Choose assets with predictable past volatility, not completely random. For example, USD/TWD has shown a clear upward trend over the past decade, making it more predictable; but currencies affected by geopolitical crises are much harder to forecast.

Third, continuously monitor changes in interest rates and exchange rates across countries. The success of carry trades depends on understanding these macro variables. Adequate data and analytical tools are essential to make the trade smoother and more controllable.

Fundamentally, carry trading is a “gambling game” in the capital markets—betting not on a specific asset’s price, but on the overall economic environment and policy direction. If you pick the right direction, you can make big money; if wrong, losses can be severe. That’s why it’s both one of the hottest topics and the riskiest game in capital markets.