What Is a Worked Example of Carry Trade?

Direct answer

A carry trade is an FX strategy where you conceptually borrow in a currency with a lower interest rate and invest (go long) in a currency with a higher interest rate. The potential return comes from the interest-rate differential, but the exchange rate between the two currencies can increase or offset that benefit. A “worked example” means laying out a full numerical scenario with explicit assumptions and calculating the cash-flow outcome.

Mechanics and definition (what is being calculated)

To make the example self-contained, we’ll define the moving parts:

• Currencies: “Funding” currency (lower interest rate) and “Investment” currency (higher interest rate).
• Interest differential: If the investment currency has a higher annual interest rate than the funding currency, the differential is the source of carry.
• Exchange-rate risk: Your profit/loss is also affected by whether the investment currency appreciates or depreciates versus the funding currency.

For clarity, assume you hold for one year and exchange at the start and end. We model simple, annual interest (not compounding intra-year) and use a single spot exchange rate at each date.

Worked numerical example (with every assumption stated)

Assume the following, with no real-time prices:

1. You start by exchanging at time 0: 1.0000 investment currency = 0.9000 funding currency. This implies: 1 funding currency = 1.1111 investment currency.
2. You borrow 1,000 units of funding currency.
3. You invest the equivalent in the investment currency, so at time 0 the invested principal is 1,000 × 1.1111 = 1,111.11 units of investment currency.
4. Interest rates (annual, simple):
   • Funding currency rate = 2% (borrow cost)
   • Investment currency rate = 6% (investment yield)
5. End of year time 1 exchange rate changes to 1.0000 investment currency = 0.9500 funding currency.
6. Ignore all frictions: no spreads, commissions, funding-credit effects, taxes, or margin costs. (These are material in real markets; we add limitations below.)

Step A: Interest you earn and interest you owe (in their own currencies)

• Investment interest earned in investment currency: 1,111.11 × 6% = 66.67
  • Investment value at time 1: 1,111.11 + 66.67 = 1,177.78 investment currency
• Funding interest owed in funding currency: 1,000 × 2% = 20
  • Amount to repay at time 1: 1,000 + 20 = 1,020 funding currency

Step B: Convert investment proceeds back to funding currency at time 1

Using the time 1 exchange rate: 1 investment currency = 0.9500 funding currency.

• Convert 1,177.78 investment currency × 0.9500 = 1,119.89 funding currency

Step C: Net result in funding currency

• Profit (simplified) = 1,119.89 − 1,020 = 99.89 funding currency

What this shows

In this scenario, the interest differential (6% − 2% = 4%) provides carry, and the investment currency also ends stronger in terms of funding currency (0.9000 → 0.9500 funding per investment currency), which amplifies the outcome.

Limitations and risks (what can break)

1. Exchange-rate reversals can dominate. If the investment currency depreciates enough, the FX loss can outweigh the interest differential. You can end up with a loss even when the investment rate is higher.
2. Costs and frictions matter. Real outcomes can be reduced by transaction costs, bid/ask spreads, rollover/funding terms, margin requirements, and operational or credit frictions. The worked example ignores these, so it may overstate results.
3. Rates and availability can change. Interest rates used at the start may not hold; refinancing and term structure effects can alter the effective funding cost and earned yield.

A practical verification mindset is to treat the carry trade like a cash-flow and FX revaluation problem: pick assumptions, compute interest on each leg, convert at the end exchange rate, and compare to the repayment amount. Then repeat the calculation under alternative exchange-rate paths to see sensitivity.

Verification and next question

If you can reproduce the steps above (interest in each currency, FX conversion, and repayment), you can independently explain how carry trade mechanics produce outcomes. For deeper understanding, examine how sensitive the result is to the end exchange rate and whether the interest differential is large or small relative to plausible FX moves.