Borrowing Japanese Yen for arbitrage, Argentina's collapse: Why is interest rate differential trading a high-risk game? Complete analysis of currency exchange arbitrage

Is Carry Trade Really That “Safe”?

Carry trade has become a focal point in the capital markets over the past two years, especially since the aggressive rate hikes in the US in 2022. Many investors have started to pay attention to arbitrage opportunities created by interest rate differentials across countries. Some confuse carry trade with arbitrage, but they are fundamentally different.

In simple terms, carry trade involves exploiting the interest rate gap between financial products. It is most common in currency markets, hence also called “interest rate arbitrage”—meaning earning from borrowing high-interest currencies and investing in lower-interest ones.

A concrete example: In 2022, borrowing Taiwanese dollars at 2% interest, then converting to USD and depositing at 5% yields, yields a 3% interest margin as profit. Sounds low-risk? But reality is far more complex than theory.

Carry Trade Looks Like a Win-Win, But Risks Are Hidden

Many believe “a country’s currency will appreciate after rate hikes,” leading them to underestimate the risks involved in carry trade.

Using Taiwan and the US as an example: In 2022, the TWD/USD exchange rate was about 1:29 (NT$2.9 million for US$10,000). By 2024, it appreciated to 1:32.6 (the same US$10,000 now equals NT$3.26 million). In this scenario, investors profit from both the interest rate differential and currency appreciation—seemingly a perfect double win.

But Argentina’s case offers a starkly opposite lesson. Due to a debt crisis, the country faced a currency collapse risk. The government adopted aggressive rate hikes, with interest rates approaching 100% (deposit NT$100, end of year NT$200). Yet, investor confidence remained fragile, and foreign capital fled. On the day of the policy announcement, the Argentine peso plummeted by 30%.

This reveals a harsh reality: raising interest rates does not guarantee currency appreciation. Exchange rate movements are influenced by complex economic and political factors. Many carry traders leverage heavily to amplify gains, which further increases risks. No one can accurately predict exchange rate trends, making carry trade inherently high-risk.

Three Hidden Risks of Carry Trade

1. Exchange Rate Risk

This is the most direct risk. When you borrow currency A to invest in currency B, a depreciation of B will directly eat into your interest margin, potentially leading to principal losses.

2. Interest Rate Risk

Interest rate differentials are not eternal—they can disappear or even reverse.

A classic case is Taiwan’s insurance industry: years ago, life insurers sold policies with fixed dividends of 6%–8%, while Taiwan’s deposit interest rates were as high as 10%–13%. People bought these policies to hedge against potential rate cuts by the government. Today, deposit rates have fallen to 1%–2%, making those 6%–8% dividend promises a huge burden for insurers.

The same narrowing of interest rate spreads also occurs in borrowing investments—like mortgage loans. Initially, rental income exceeds mortgage interest, but if mortgage rates rise or rents fall, it can turn into a loss.

3. Liquidity Risk

Not all financial products can be easily exited. Some assets bought at NT$100 may only be sold at NT$90; some transactions involve high fees; long-term contracts like insurance only allow policyholders to cancel, while issuers cannot actively cut losses.

When interest rates rise or exchange rates deteriorate, you may want to exit but find no buyers or face high cancellation costs—that’s the destructive power of liquidity risk.

How to Hedge Carry Trade Risks?

The core idea of hedging is using opposite-positioned financial products to offset risk and return.

Real-world example: A Taiwanese factory receives a US$1 million order, expecting payment in one year. The factory knows that US$1 million equals NT$32.6 million now but is uncertain about the exchange rate in a year. They can buy forward FX swaps to lock in the rate—giving up potential currency appreciation gains for stability.

However, locking in the rate incurs costs, which are often not fully offset by expected gains. In practice, investors rarely lock the entire position from start to finish. Usually, they hedge only when facing uncontrollable risks (like holiday or holiday-long weekend risks). Otherwise, they often close positions early to repay original loans.

The Yen Carry Trade: The World’s Largest Arbitrage Game

The biggest global carry trade involves borrowing Japanese yen to invest in higher-yield assets. Why? Because Japan offers unique advantages:

• Political stability, currency stability, and extremely low interest rates—a rare combination among developed countries
• Yen is easy to borrow—the Japanese government maintains zero or negative interest rate policies to encourage borrowing and stimulate inflation

While the Eurozone also had long-term zero rates, large-scale euro arbitrage by international investors is rare, highlighting Japan’s unique financing advantage.

Strategy 1: Borrow low-interest Yen, invest in high-yield assets

International investors borrow large amounts of yen from the Bank of Japan using USD or their own assets as collateral, then invest in high-yield currencies and financial products in the US, Europe, or real estate. The income from these assets is used to pay interest, with surplus used to repay principal early.

Because yen borrowing costs are extremely low, even if exchange rates weaken slightly at maturity, the overall investment can still be profitable.

Strategy 2: Buffett’s Japanese Stock Acquisition Play

During the post-pandemic QE frenzy, Buffett believed US stocks were overvalued and turned to undervalued Japanese stocks. He used Berkshire Hathaway to issue bonds (cheap financing), then invested in Japanese blue-chip stocks. He then pushed for higher dividends, stock buybacks, and pressured companies on the Tokyo Stock Exchange to improve liquidity, reduce cross-shareholdings, and keep stock prices above net asset value—threatening delisting otherwise.

This combo brought Buffett over 50% profit in just two years, and since borrowing and investing are all in Japan, it completely avoids exchange rate risk because dividend yields exceed debt costs. For large capital with board-level influence, this is an extremely low-risk arbitrage.

Carry Trade vs. Arbitrage: What Is the Fundamental Difference?

Arbitrage generally refers to “riskless profit”—buying low and selling high across different markets for the same product, exploiting price, information, or regional differences.

Carry trade involves actively taking on risk—investors commit capital to assets with interest rate differentials, accepting exposure to exchange rate, interest rate, and liquidity fluctuations.

This is the most fundamental difference.

Keys to Success or Failure in Carry Trade

Successful carry trades start with timing. You must clearly define how long you plan to hold the position to choose suitable assets for earning the interest differential.

Next, analyze the historical relative price movements of your investment targets. Preferably, select assets with strong cyclical patterns. For example, USD/TWD exchange rates tend to fluctuate periodically; historical data can help identify better entry points.

Finally, understand the relationship between interest rates and exchange rate changes. Building such an analytical framework allows for smarter decisions in currency arbitrage, reducing the risk of blind entry.

In short, carry trade is not a “sure-win” investment. It requires careful planning, thorough preparation, and strict risk control—an advanced trading strategy.