What is Carry Trade?

Definition
The definition of carry trade from Investopedia is a trading strategy that involves borrowing at a low-interest rate and investing in an asset that provides a higher rate of return. It is typically based on borrowing in a low-interest rate currency and converting the borrowed amount into another currency.

The Risk of Carry Trade
1. When the invested assets are declining sharply in price, carry trade investors should take risk.
2. Currency risk of invested currency will later be a burden. When the invested currency value tumbles, investor would have more deficit even thought the interest rates (rewards) are higher.

Japan is the best example of carry trade investment. Since natural disaster such as earthquake or typhoon is occurred frequently in Japan, indemnity insurance companies are obliged to compensate the losses. That is why Japanese investors were seeking for more gains, which later lead to FDI (Foreign Direct Investment) or foreign bonds. Recently, Japan is the largest net creditor country is the world. However, this kind of investment can negatively affect the economy.

For example, Japanese yen had reached about $1 trillion of carry trade investment due to its long low policy rate. However, when the global economy strikes to recession during 2008 financial crisis, the invested asset value was deteriorated. Japan started to sell off the foreign assets which is making Japanese Yen soars high.

It also happened during the worst earthquake (Kobe) in January 1995. Japanese Yen has tumbled until 1USD = 80JPY, due to withdrawal against carry trade investment. It was only 5 years after Japanese asset price bubble blasted, Japan had the worst domestic economy, troubled with insolvent assets. However, due to strong Japanese currency value, their exported started tumbling, making their economy go even worse. About 4 months later, Japan agreed to have anti-Plaza agreements, leaving Japanese Yen weakening its value.
(South Korea attempted to expand more on Capex investment since Japan had hard time with high JPY. They might have took it as great opportunity for their export. Unexpected anti-Plaza accord was one of the reason that lead South Korea in currency crisis.)