What is the carry trade and how is it used in crypto?

What is the carry trade?

The carry trade (English: carry trade) is a strategy in which investors borrow in a currency with a low interest rate and invest in assets denominated in a currency with a higher interest rate to earn the spread.

The term has no standard Russian translation; one possible rendering is “interest-rate arbitrage”.

How does the carry trade work in traditional markets?

One of the best-known examples is the classic yen–dollar strategy. For years, investors borrowed Japan’s currency and invested in dollar assets that offered much higher yields. The trade was profitable while the interest-rate gap was favourable and the yen did not suddenly jump against the dollar, which occurred in July 2024.

Potential profits can be meaningful, but such trades are highly sensitive to global conditions and investor sentiment. If the backdrop deteriorates, winning positions can quickly turn problematic. To prevent losses from currency moves from exceeding interest income, risks should be hedged.

Other examples:

• interest rates are also low for the Swiss franc (CHF). Investors can borrow francs and invest in assets in New Zealand dollars (NZD), where rates are typically higher, capturing the spread;
• the euro (EUR) also carries relatively low rates, while Turkey’s are significantly higher owing to inflation. Investors can borrow the EU currency and invest in the lira (TRY) to obtain higher yields, though this trade is risky because of TRY volatility.

Consider a carry trade with simultaneous long and short positions in the yen and the Australian dollar (AUD).

Steps:

• the investor borrows yen at a low interest rate—for example, 0.1% per annum;
• then converts the funds into AUD and invests in higher-yielding Australian bonds—say, at 4% per annum;
• thus, the investor is long the AUD/JPY pair to profit from a potential strengthening of the Australian dollar against the yen;
• to hedge currency risk, a short position in AUD/JPY futures is opened simultaneously for an equivalent notional. This helps lock in the current exchange rate and protect returns from FX swings.

Result:

• the investor earns the difference between the bond yield (4%) and the yen funding cost (0.1%);
• the short position protects against a possible fall in AUD/JPY.

How does the carry trade work in the crypto market?

DeFi gives users anywhere broad scope to maximise returns on cryptoassets. This multifaceted segment offers several ways to implement a carry-trade strategy.

A hypothetical set-up with the following inputs:

• cryptoasset 1: ABC — a US dollar-pegged stablecoin; borrowing rate 2% per annum;
• cryptoasset 2: XYZ — a volatile cryptoasset with a relatively small float; DeFi platform rate 8% per annum;
• current XYZ/ABC rate: 30,000 (1 XYZ = 30,000 ABC).

Steps:

• the investor borrows 100,000 ABC at 2% per annum on a centralised exchange or via a DeFi lending service;
• then converts 100,000 ABC into XYZ at the current rate, receiving 100,000 / 30,000 = 3.33 XYZ;
• the investor deposits 3.33 XYZ into a DeFi protocol offering 8% per annum on that asset;
• to hedge the XYZ price risk, the trader opens a short position in futures or options on the XYZ/ABC pair for 3.33 XYZ at the current rate (30,000 ABC per 1 XYZ).

After a year:

• income from the XYZ deposit: 3.33 XYZ * 8% = 0.266 XYZ;
• cost of servicing the ABC loan: 100,000 ABC * 2% = 2,000 ABC;
• conversion of XYZ back into ABC: if the rate remains 30,000, the investor receives 3.596 XYZ * 30,000 ABC/XYZ = 107,880 ABC;
• futures settlement (if the price stays at 30,000): the short position incurs no loss because the rate is unchanged.

Bottom line:

• income expressed in the stablecoin: 0.266 * 30,000 = 7,980 ABC;
• net profit in the stablecoin: 7,980 — 2,000 = 5,980 ABC.

Thus, over a year the investor earns nearly 6% on the difference between borrowing in the stablecoin and investing in the volatile XYZ, while minimising currency risk through a futures hedge.

What is cash-and-carry arbitrage?

Despite the similar names, there is a significant difference between the carry trade and cash-and-carry arbitrage. The latter is a strategy that exploits the gap between an asset’s current spot price and its futures price. It involves buying the instrument on the spot market and simultaneously selling (shorting) a derivative contract on the same asset.

How it works:

1. Buy on the spot market (cash). The trader acquires the asset at the current price — for example, bitcoin for USDT.
2. Short the future (carry). The trader simultaneously sells a derivative contract on the same asset, agreeing to deliver BTC in the future at a pre-set price.
3. Close the position. At the futures expiry, the trader closes both legs: the asset bought on spot is sold and used to fulfil the contract.

Suppose that at initiation:

• bitcoin’s spot price is 50,000 USDT;
• a one-month BTC future trades at 50,200 USDT;
• the trader buys 1 BTC for 50,000 USDT and simultaneously shorts a contract for 1 BTC at 50,200 USDT.

Regardless of how bitcoin’s price changes, the trader receives:

• the sale of 1 BTC via the futures contract for 50,200 USDT;
• the return of the initial 50,000 USDT outlay;
• an ultimate profit equal to the difference between the futures price and the spot price at the time of the trade — in this example, 200 USDT.

This strategy works when the future trades at a premium to spot (the contract price is above the underlying). Such a situation can arise from expectations of a rally, fundamentals like the time value of money, or market imbalances.

Cash-and-carry arbitrage allows this difference to be locked in as profit with minimal risk. It is popular among hedge funds and institutional investors, as it can deliver relatively safe returns in various market conditions.

What are the advantages of the carry trade?

The carry trade is one of the most popular and effective long-term strategies in financial markets, especially among professionals. But to maximise gains and reduce potential losses, sound risk management matters — notably through portfolio diversification.

Building a basket of several assets with different yields helps reduce the probability of losses. If one instrument underperforms, others can offset it, supporting portfolio stability.

This approach is widely used by investment banks and hedge funds. With appropriate position sizing, private investors can adopt it too.

The carry trade involves holding positions for extended periods, which makes the strategy attractive to market participants with lower risk tolerance and a long-term horizon. The main advantages include steady interest income from the currency pair and potential gains if exchange rates move favourably.

Implementation often focuses on assets with the widest interest-rate spreads. However, it is important to consider economic shifts that can affect returns, as well as market volatility. Using relatively safe instruments reduces risk but may also curb potential returns.

What are the pitfalls of the carry trade?

Like any investment strategy, the carry trade carries risks; the main one is currency risk.

If the funding currency suddenly strengthens against the asset you invested in, profits can evaporate or even turn into losses when converted back.

To some, the carry trade may seem like an easy way to make money, but it can tie up capital for a long time. That deprives traders of the chance to pursue potentially more profitable opportunities.

In cash-and-carry, the difference between futures and spot prices is often small relative to the position sizes needed to make the strategy worthwhile. This ties up even more capital for the strategy to be effective.

Traders can reduce the required capital for cash-and-carry by using leverage on the futures leg. But the risks of leverage must be considered. If market swings trigger liquidation, the trader will lose money on a trade designed to remove directional risk.

Using perpetual swaps entails greater risk than fixed-maturity futures. With a set settlement date, the futures price almost always tends to converge to spot. Over time the spread on perpetuals should also narrow, allowing profitable exits. However, if the market shifts from contango to backwardation, it may take considerable time before an opportunity arises to close positions profitably. That can mean either missing other attractive options or closing the trade at a loss.