Carry Trades

Funding and Target Currencies: Choosing the Right Pair

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Funding and Target Currencies: Choosing the Right Pair

A carry trade consists of two currency legs: the funding currency, borrowed at a low interest rate, and the target currency, invested at a higher rate. The choice of these two currencies determines whether a carry trade succeeds or fails. The funding currency should be issued by a central bank committed to low rates over a long period; the target currency should offer attractive yields with acceptable risk. Historically, the Japanese yen, Swiss franc, and euro have dominated as funding currencies due to their low policy rates and the deep, liquid forex markets surrounding them. Target currencies have varied: the Australian dollar and New Zealand dollar in the 2000s and 2010s, emerging-market currencies like the Brazilian real and South African rand, and occasionally higher-yielding developed-market currencies when rate cycles shift. Understanding which currencies to pair depends on analyzing central bank policy, yield spreads, currency stability, and liquidity. A trader must select a funding currency expected to remain weak (low-rate) and a target currency expected to remain strong (high-yield) for at least the duration of the carry trade.

The selection of funding and target currencies is not arbitrary; it follows the structural incentives created by central bank policy. When the BoJ commits to maintaining ultra-low rates, it becomes the natural funding choice for investors globally. When the RBA raises rates to combat inflation, Australia becomes an attractive target. These structural choices persist across years or decades, creating relatively stable carry-trade ecosystems. However, regime changes—the BoJ ending negative rates, the Reserve Bank of Australia cutting rates—disrupt these pairings and trigger carry-trade unwinding.

Quick definition: A funding currency is borrowed in a carry trade because its central bank maintains low rates; a target currency is invested in because it offers higher yields. The pair (e.g., yen/Australian dollar) is the fundamental unit of the carry-trade strategy, and pair selection is the first decision a carry trader must make.

Key Takeaways

Funding currencies are chosen by low-rate central banks: The BoJ, SNB, and ECB have historically dominated because their policy rates are reliably low and their currencies are liquid.
Target currencies offer yields high enough to justify leverage and risk: Yields of 4%+ are common targets; yields below 2% typically don't justify the operational complexity.
Emerging-market currencies often serve as targets but introduce political and credit risk: Brazil, India, and South Africa offer 6–10% yields but face higher volatility and default risk.
The funding currency's stability matters more than its absolute rate level: A 1% rate with a stable currency is more valuable than a 0.5% rate with a depreciating currency.
Forward guidance from central banks determines pair attractiveness: A central bank signaling future rate hikes reduces its appeal as a funding currency; one signaling rate cuts becomes more attractive as a target.
Currency liquidity is critical: A 5% yield is worthless if the currency is illiquid and cannot be easily sold. Major emerging markets (Brazil, India) have liquid markets; smaller countries do not.

The Characteristics of Ideal Funding Currencies

An ideal funding currency has three critical characteristics: low policy rates, stable or declining rates expected, and deep forex and money-market liquidity.

Low Policy Rates: The funding currency must offer the lowest rates available globally. The BoJ's historic 0–0.5% rate has been the global floor for decades. Anything below that rate (negative rates in Japan, Switzerland, and the eurozone from 2015–2022) is extraordinarily low. A funding currency yielding 3–4% is much less attractive because the carry spread narrows; borrowing at 3% and lending at 5% nets only 2%, whereas borrowing at 0.5% and lending at 5% nets 4.5%.

In 2024, the Bank of Japan's 0.5% rate remains one of the lowest globally, making yen the natural funding choice. The Federal Reserve's 5.25–5.50% rate is the highest among major central banks, making dollars an unattractive funding currency (though attractive as a target for investors paying even higher rates elsewhere).

Rate Expectations: Carry traders must believe the funding currency's interest rate will remain low for the duration of their position (often months or years). Forward guidance from central banks is critical. When the BoJ states that rates will remain at 0% for years, carry traders feel confident borrowing yen for 5-year carry trades. When the Fed signals future rate hikes, investors reduce dollar borrowing and shift to other currencies.

The most dangerous shift occurs when a central bank that has been accommodative suddenly turns hawkish. The Swiss National Bank's decision to remove the EUR/CHF peg in January 2015 after six years of maintaining it destroyed carry traders' confidence in the franc's stability. Similarly, the BoJ's surprise rate hike in March 2024, after 17 years of holding rates near zero, prompted rapid carry-trade unwinding.

Central bank communication is therefore a primary driver of carry-trade flows. When a central bank hints at future hikes, carry traders begin reducing positions preemptively, causing the currency to appreciate before the actual rate move. By the time the rate hike occurs, much of the carry-trade unwinding has already happened.

Forex and Money-Market Liquidity: The funding currency must be easily tradeable in large volumes without significant slippage. The yen, dollar, euro, pound, and Swiss franc are highly liquid; they trade 24/5 in massive volumes globally. An investor wanting to borrow JPY 100 billion (roughly USD 1 billion equivalent) can access this funding quickly through repo markets, forex swaps, or interbank lending.

Less liquid currencies are problematic for carry traders. A small emerging-market currency like the Czech koruna or Polish zloty might offer good yields relative to the yen, but if the carry trader wants to unwind a large position quickly, liquidity may evaporate and prices move sharply against him. Liquidity becomes critical during unwinding events when all carry traders race for the exits simultaneously.

The Characteristics of Ideal Target Currencies

An ideal target currency offers high yields, with low currency volatility and acceptable political/credit risk. Target-currency selection is more nuanced because traders must balance yield (the primary return driver) against currency risk.

High Yields: A target currency should offer yields substantially higher than the funding currency. If the funding currency yields 0.5% and the target yields only 1.5%, the 1% spread is modest and barely justifies leverage. Most carry traders target spreads of 3–5%+. This is why commodity-exporting countries with emerging-market status (Australia, New Zealand, Brazil, South Africa, Canada) are natural targets. Their central banks set higher rates to manage inflation and currency stability, creating spreads of 4–10% relative to the yen.

Yields are often correlated with risk. A country offering 8% yields likely faces higher inflation, political uncertainty, or currency depreciation risk compared to a country offering 4% yields. Carry traders must estimate whether the extra 4% yield compensates for the additional risk.

Currency Stability: The ideal target currency appreciates or remains stable against the funding currency. A trader borrowing yen and investing in Australian dollars hopes the AUD/JPY rate either increases (AUD appreciation, favorable) or stays flat. If the AUD depreciates against the yen, the currency loss erodes the interest-rate carry.

For example, if a carry trader enters AUD/JPY at a spot rate of 100 JPY/AUD and after one year the rate is 95 JPY/AUD (yen strengthens), the trader must convert AUD proceeds back to yen at a worse rate, incurring a 5% currency loss. The 3.5% interest carry is insufficient to cover this loss; the net loss is 1.5% despite earning positive interest-rate spread.

Historical currency stability is important but not perfect. The AUD/JPY pair has been volatile, ranging from 55 to 110 over the past 20 years. Traders who held during the 2008 crisis suffered devastating currency losses even though they earned interest-rate spread.

Political Risk and Credit Risk: The ideal target currency is issued by a politically stable country with a low default risk. Advanced democracies (Australia, Canada, New Zealand) present minimal political risk; their currencies are managed by independent central banks, and government bonds are backed by stable tax bases. Emerging markets introduce political risk; a change in government or policy could trigger currency depreciation or default.

Credit risk—the risk that the issuer of target-currency assets (government or corporation) will default—is also important. Buying Australian government bonds has essentially zero credit risk (Australian government default is virtually impossible); buying Brazilian corporate bonds carries real default risk. Carry traders operating in emerging markets must carefully select which assets to invest in.

Major Funding Currencies and Their Historical Roles

The Japanese Yen (JPY): The yen has been the dominant funding currency since the late 1990s when the Bank of Japan cut rates to near-zero. The BoJ maintained rates at 0–0.5% for over 20 years, making the yen the global rate floor. Japanese institutional investors (insurers, pension funds, banks) have access to the cheapest yen funding through the interbank market and central bank operations. This structural advantage has made yen carry trades the largest subset of global carry trades.

The yen's dominance rests on three factors: (1) the BoJ's persistent commitment to low rates, (2) Japan's large institutional investor base with global investment mandates, (3) the yen's status as a safe-haven currency, making it the preferred currency for defensive investors to hold.

In 2024, the BoJ began raising rates, reducing the yen's appeal as a funding currency. Each 25-basis-point hike narrows carry spreads by 25 bp, making yen carry trades less profitable. If the BoJ reaches 1–2% over the next few years, yen carry trades will shrink dramatically.

The Swiss Franc (CHF): The SNB has often maintained rates below the Fed's rate, making the franc attractive as a funding currency. From 2010–2015, the SNB held rates near zero and negative while maintaining an EUR/CHF peg at 1.20, explicitly trying to weaken the franc to protect Switzerland's export economy. This created an enormous spread between the franc (negative rates) and emerging-market currencies (8–10%), driving massive carry-trade accumulation in franc-funded positions.

However, the franc's role as a safe-haven currency introduces volatility. During risk-off events (equity market crashes, geopolitical crises), capital flows into the franc, strengthening it regardless of interest-rate expectations. A carry trader funding in francs and investing in emerging markets faces severe losses during crises when the franc rallies. The January 2015 SNB surprise exemplified this dynamic; when the SNB abandoned the peg, the franc surged 30% and devastated leveraged carry positions.

The Euro (EUR): The European Central Bank's rates have varied more than the BoJ's. From 2014–2021, the ECB held rates near zero. From 2022 onward, it raised rates to 4%+, reducing the euro's appeal as a funding currency. Euro carry trades have been less popular than yen carry trades, partly because euro rates are higher, and partly because the eurozone's complexity (19 member countries with different credit risks) introduces complications.

The U.S. Dollar (USD): The Federal Reserve's policy rate has typically been higher than the BoJ's and SNB's, making dollars a less attractive funding currency. However, during periods when the Fed cuts rates dramatically (2008–2009, 2020), the dollar briefly becomes attractive for carry funding. The dollar's status as the global reserve currency, combined with deep repo and lending markets, makes dollar borrowing liquid and accessible even at higher rates.

Major Target Currencies and Their Characteristics

The Australian Dollar (AUD): The Reserve Bank of Australia (RBA) has maintained rates above the BoJ's since the late 1990s. The RBA's rate hit 6.25% in 2008, creating an enormous 5.75% spread over the yen. Australia's natural-resource wealth (iron ore, coal, gold), English-language business environment, and regulatory stability have made the AUD an attractive target. The AUD carry trade was the dominant carry pair from 2003–2013.

However, the AUD is commodity-linked; it depreciates when commodity prices fall. During the 2008 crisis, the AUD fell sharply (though it later recovered), hitting carry traders with large unrealized losses despite earning interest-rate spread.

The New Zealand Dollar (NZD): The Reserve Bank of New Zealand (RBNZ) has maintained rates comparable to or higher than the RBA's, making the NZD a popular target. The NZD/JPY pair has been a workhorse carry trade, generating steady returns. Like the AUD, the NZD is commodity-linked and depreciates during risk-off events.

Brazilian Real (BRL): Brazil offers high yields (8–11% in recent years) relative to the yen (0.5%), creating a 7.5–10.5% spread. This enormous spread attracts carry-trade capital, but Brazil faces higher inflation, political risk, and currency volatility. A trader investing in BRL must accept the risk of sharp depreciation (which has occurred periodically) in exchange for higher yields.

South African Rand (ZAR): The South African Reserve Bank (SARB) maintains rates in the 4–8% range, higher than the yen. The ZAR/JPY pair offers 3.5–7.5% spreads. South Africa, like Brazil, faces higher political and credit risk but offers compelling yield differentials.

Other Emerging Markets: Indian rupee, Mexican peso, and Indonesian rupiah have all served as carry-trade targets at various times. These currencies offer yields of 5–8% relative to the yen, but introduce currency and political risks that professional traders carefully evaluate.

The Interaction Between Funding and Target Currency Selection

Carry traders do not select funding and target currencies independently; they work as a pair. The relative attractiveness of a carry pair depends on both the funding-currency rate expectations and the target-currency yield and risk profile.

When analyzing AUD/JPY, a trader considers:

Will the BoJ keep rates low? If the BoJ signals future hikes, the pair becomes less attractive.
Will the RBA maintain or raise rates? If the RBA cuts rates, the spread narrows.
What is the AUD's currency risk? If commodity prices are falling, AUD depreciation is likely.
What is the relative leverage available? If Japanese banks offer 20:1 leverage on yen funding, the pair is more attractive than one accessible only at 5:1.

A trader might decide that AUD/JPY is unattractive because (1) the BoJ is about to raise rates, narrowing the spread, and (2) commodity prices are weakening, risking AUD depreciation. Instead, the trader might shift to NZD/JPY or BRL/JPY, finding better risk-reward profiles.

This dynamic explains the evolution of dominant carry pairs over time. Before 2008, AUD/JPY was the favorite. After the Australian mining slowdown (2011–2015), traders shifted to NZD/JPY and emerging-market currencies.

Real-World Examples of Funding and Target Currency Pairs

The AUD/JPY Boom (2003–2008): The RBA set rates at 6.25% while the BoJ maintained rates near 0%. The spread exceeded 6%, justifying high leverage. Japanese insurers and pension funds became the primary source of yen carry funding, and Australian assets were the target. The pair traded up from 60 JPY/AUD to nearly 105 by mid-2008, a 75% appreciation in the AUD. This combination—high interest-rate spread, favorable currency move, and rising global asset prices—generated exceptional returns for AUD/JPY carry traders.

The Franc/Emerging Market Boom (2010–2015): The SNB maintained negative rates and a strong commitment to weakening the franc. Emerging markets like Brazil and Turkey offered 8–12% yields. The differential between CHF and BRL was 10%+ annually, and the franc was expected to weaken further (or stay weak) due to SNB policy. Massive carry-trade capital accumulated. When the SNB abandoned the peg in January 2015, the strategy collapsed; the franc surged 30% in an afternoon, forcing liquidations and turning enormous profits into losses for some traders while others were entirely wiped out.

The NZD/JPY Recovery (2013–2019): After the 2008 crisis, the RBNZ gradually raised rates while the BoJ remained accommodative. NZD/JPY became a popular alternative to AUD/JPY, with spreads around 4–5% and favorable currency trends (NZD appreciated broadly). This pair generated steady returns for carry traders during a relatively calm period.

The Emerging-Market Carry (2020–2023): With the Fed and BoJ near-zero, emerging-market currencies like BRL, INR (Indian rupee), and ZAR offered 5–10% spreads over yen. Institutional investors accumulated large positions. However, the political uncertainties in Brazil and inflation concerns globally created volatility, limiting the sustainability of these positions.

Real-World Mechanics: Evaluating a Potential Carry Pair

Suppose a trader is considering establishing a yen-funded carry trade and must choose between AUD (target A) and BRL (target B):

AUD/JPY Analysis:

JPY rate: 0.5%, RBA rate: 4%, spread = 3.5%
Currency risk: Moderate (AUD commodity-linked, but developed-market currency)
Yield on AUD assets: 4–4.5% (government bonds)
Effective funding cost in yen: 0.5% + 0.2% spread = 0.7%
Net carry: 4.2% - 0.7% = 3.5% plus interest on compounding
Leverage available: 10:1 (yen is major currency)
Expected holding period: 2–3 years, anticipating RBA rate cuts
Risk assessment: Low political risk, moderate currency risk, good liquidity

BRL/JPY Analysis:

JPY rate: 0.5%, Brazilian central bank rate: 10.5%, spread = 10%
Currency risk: High (BRL is emerging-market currency with high volatility)
Yield on BRL assets: 10–11% (government bonds or corporate bonds)
Effective funding cost in yen: 0.5% + 0.3% spread = 0.8%
Net carry: 10.1% - 0.8% = 9.3% plus interest on compounding
Leverage available: 5:1 (emerging-market funding is less liquid)
Expected holding period: 1–2 years (nervous about political stability)
Risk assessment: High political risk, high currency risk, moderate liquidity

Comparison: The BRL/JPY pair offers a 9.3% net carry versus 3.5% for AUD/JPY, a 265% higher return. However, the BRL pair accepts 5:1 leverage versus 10:1 for AUD, has higher political and currency risk, and requires a shorter holding period. A trader choosing AUD/JPY is accepting lower returns in exchange for lower volatility and longer-term sustainability. A trader choosing BRL/JPY is gambling that the high carry spread will outweigh currency and political risks.

Most institutional carry traders operate both pairs simultaneously, with position sizing reflecting their risk tolerance. During periods of low volatility, leverage is increased; during periods of high political risk, the BRL position is reduced.

Flowchart of Funding and Target Currency Selection

Common Mistakes in Funding and Target Currency Selection

Assuming a funding currency's low rates are permanent: Carry traders have been surprised repeatedly by central banks that were expected to keep rates low but eventually raised them. The BoJ was expected to raise rates for 17 years but didn't until 2024, confusing many traders.
Selecting a target currency based solely on yield without assessing currency stability: A country offering 12% yields might face 20% annual depreciation, turning the high-yield target into a currency loss trap. Brazil's experience from 2013–2015 exemplified this mistake.
Ignoring central bank forward guidance: Central banks telegraph major policy shifts months in advance. The SNB's January 2015 surprise was rare; most policy changes are signaled. Traders who ignore signals are caught off-guard.
Focusing on headline central bank rates rather than market-implied funding costs: A trader might assume yen funding at the BoJ's 0.5% rate, but actual costs in repo or swap markets might be 0.8–1.2%. The spread is narrower than expected.
Selecting emerging-market target currencies without sufficient political-risk assessment: A trader might be attracted to a 10% yield without understanding that the country's government faces an election, political instability, or currency reform plans. Political events can trigger 20–30% currency depreciations regardless of interest rates.
Failing to rebalance as central bank policy changes: A carry trader who establishes a position when spreads are wide (3.5%+) must monitor for narrowing spreads. If the funding-currency central bank signals rate hikes, reducing position size or adding hedging becomes essential.

FAQ

Can a trader use two target currencies in a carry-trade portfolio?

Absolutely. Many institutional carry traders operate "baskets" of carry positions. A hedge fund might run 10% of capital in AUD/JPY, 10% in NZD/JPY, 5% in BRL/JPY, and 5% in other emerging-market pairs. This diversification reduces reliance on any single pair and allows for dynamic rebalancing. However, during unwinding events, all pairs tend to move together as carry traders simultaneously liquidate, so diversification benefits are limited during crises.

What makes a currency a better funding currency than a target?

A better funding currency has lower rates (often from a deliberate central bank policy), greater liquidity, and stable or declining rate expectations. A better target currency has higher rates and lower currency volatility. The assignment is not absolute; the same currency can be a funding currency in one carry pair and a target in another if rate spreads shift. However, the JPY, CHF, and EUR have historically been funding currencies, while AUD, NZD, and emerging-market currencies have been targets, reflecting persistent structural differences.

How do traders decide whether to hedge the currency risk in their target currency?

Hedging involves buying a forward contract to lock in an exit price for the target currency. A trader might hedge 50% of the AUD position, locking in a JPY/AUD rate and leaving 50% unhedged to benefit from potential appreciation. Hedging costs money (the forward premium incorporates interest-rate differentials), so full hedging can reduce net carry returns to zero—theoretically, a fully hedged carry trade should break even due to covered interest rate parity. Most carry traders accept some unhedged currency exposure because the interest spread is attractive enough to compensate for modest currency moves.

Why don't all carry traders focus on the widest spread (e.g., yen/Brazil)?

The widest spreads often correspond with the highest risks. A 10% spread in BRL/JPY is appealing, but if the Brazilian currency depreciates 15% during the holding period, the interest carry does not compensate. Carry traders evaluate spreads on a risk-adjusted basis. A 3.5% spread with 5% currency volatility (AUD/JPY) might be more attractive on a Sharpe-ratio basis than a 10% spread with 30% currency volatility (BRL/JPY).

Can a central bank deliberately weaken its currency to encourage carry-trade funding?

Yes, and the SNB is the most famous example. From 2010–2015, the SNB maintained negative rates and a EUR/CHF peg at 1.20, explicitly trying to weaken the franc by making it unattractive to hold. Japan's government has occasionally expressed interest in weakening the yen to help exporters, though the BoJ maintains formal independence from political pressure. Most central banks do not actively try to encourage carry trades; they focus on price stability and financial stability mandates. However, accommodative policy (low rates) does inadvertently encourage carry-trade funding in that currency.

What happens if both the funding and target currencies experience rate hikes?

The spread narrows. If the BoJ raises rates from 0.5% to 1.5% and the RBA raises rates from 4% to 5%, the AUD/JPY spread falls from 3.5% to 3.5% (unchanged in this case). However, if the BoJ raises by 50 bp and the RBA raises by 25 bp, the spread narrows by 25 bp, reducing carry returns. This dynamic happened when central banks tightened at different speeds post-2021; the BoJ remained accommodative while other central banks raised aggressively, briefly widening spreads, then narrowing them as the BoJ eventually followed.

External Resources

Bank for International Settlements (BIS): Exchange Rates and Capital Flows — https://www.bis.org/statistics/index.htm — Tracks funding and target currency flows in global carry-trade markets.
Federal Reserve Economic Data (FRED): Interest Rates by Country — https://fred.stlouisfed.org/ — Historical interest rates for major central banks, useful for analyzing funding-currency choices.

Summary

The choice of funding and target currencies is the foundational decision in carry trading. Funding currencies should be issued by central banks committed to low rates (the BoJ, SNB, ECB) and be deeply liquid; target currencies should offer attractive yields with acceptable risk. The interaction between the two determines the spread and the overall risk-adjusted return. Historically, the yen has dominated as the funding currency and the Australian/New Zealand dollars and emerging-market currencies as targets, creating a relatively stable carry-trade ecosystem. However, regime changes in central bank policy or fundamental currency strength can rapidly shift the attractiveness of pairs, requiring traders to continuously reassess funding and target currency selections to maintain profitable positions.