Why do investors borrow in yen to buy Australian dollars?

If holding the higher-rate currency pays a differential, the obvious next thought is to hold only the higher-rate currency and to fund it with the lower-rate one. That trade has a name — the carry trade — and it is the most consequential positioning behaviour in the FX market. This lesson explains the mechanics and the arithmetic. It is not a recommendation to do it, and the next lesson is about how it ends.

The mechanics, step by step

Suppose the Japanese overnight rate is 0.50% and the Australian one is 4.50%, with AUD/JPY at 100.00 — that is, 100 yen per Australian dollar. The trade has four legs:

1. Borrow yen at 0.50%.
2. Sell the yen and buy Australian dollars at spot.
3. Hold the Australian dollars in an Australian money-market instrument at 4.50%.
4. At the end, sell the Australian dollars, buy yen, and repay the loan.

The arithmetic

Borrow ¥150,000,000 for one year.

Convert at 100.00: 150,000,000 / 100 = A$1,500,000

Invest at 4.50%: 1,500,000 × 1.045 = A$1,567,500

Repay the yen loan: 150,000,000 × 1.005 = ¥150,750,000

If the exchange rate is unchanged at 100.00, converting back gives 1,567,500 × 100 = ¥156,750,000, leaving

156,750,000 − 150,750,000 = ¥6,000,000

which is 4.0% of the amount borrowed — precisely the 4.00 point differential. That is the whole idea in one number.

The number that actually matters

Now solve the other way. At what exchange rate does this trade break even? You need enough yen to repay ¥150,750,000 from A$1,567,500:

150,750,000 / 1,567,500 = 96.17

The Australian dollar only has to fall from 100.00 to 96.17 — a 3.83% decline — to erase a full year of a four-point interest advantage. Write that number down. It is the single most important line in this unit, and Unit 2 will show you that 96.17 is not a coincidence: it is exactly the one-year forward rate.

Leverage turns a small number into a large one

In practice almost nobody funds this with cash deposits. The same exposure is expressed in a single FX forward or FX swap, where the position is collateralised with margin rather than paid for in full. Post an illustrative 5% margin and the 4.0% return on notional becomes about 80% on the capital posted — and the 3.83% adverse move that used to cost a year of carry now costs roughly three-quarters of the capital.

Leverage does not change the trade. It changes how far the exchange rate has to travel before the trade changes you.

What is really being sold

Strip away the plumbing and the carry trade is a bet that the high-yield currency will not depreciate by the interest differential. Textbook theory says it should — on average, exactly by that much. Unit 2 states that theory formally and shows what the data actually did. For now, hold two facts together: the carry is collected in small daily instalments, and the risk is realised in a single large one.

This lesson describes a widely observed market behaviour. It is education, not a strategy, and the Academy makes no claim about what any currency will do.

In the data

The two legs of a carry calculation are rarely measured the same way. A central bank publishes a target; the market borrows at a benchmark that trades near it and not on it. Below are both for the dollar: the Fed's target band, then SOFR, the overnight rate at which dollars were actually lent against Treasury collateral.

Mixing a benchmark on one leg with a policy target on the other yields a carry figure that is part measurement and part apples-to-oranges. Use the same kind of rate on both sides, and say which.

Try it now

1. The Fed's band is above and the Bank of England's rate is below, latest day each. What is the annual differential in percentage points, and which end of the Fed's band did you use? Note what you are holding: target rates, not the benchmarks anybody actually borrows at.

2. The latest AUD/JPY close is below. Compute the one-year breakeven exchange rate using the method above, with the lesson's 4.50% and 0.50% standing in for the Australian and Japanese rates. The Reserve Bank of Australia and the Bank of Japan publish the real ones on their own websites.

3. Express that breakeven as a percentage move from spot. Then Measure the last three years of AUD/JPY on the chart below and count how many times the pair moved by at least that much inside twelve months.