Carry trades are transactions in which individuals borrow at a low rate and invest at higher ones. Generally, carry trades are executed in the currency markets, where investors try to take advantage of interest rate differences between countries.

Q. So this is a currency strategy, right? Borrow in a country where the interest rates are low, and invest the proceeds in a country where interest rates are high.
A. Yes, precisely. Technically, the term can apply to any situation in which you borrow at a low rate and invest at a higher one, but usually people mean the currency carry trade you just described. So, an investor would borrow, say, Japanese Yen at essentially zero interest rate and invest the proceeds in, say, Australian dollar bonds at maybe 4%. A ten million dollar trade would net you $400,000 while you do nothing at all.

Q. Sounds like easy money! And we know that means there’s a big risk somewhere.
A. Indeed. If the exchange rates don’t change, you’re fine. And if the Yen deppreciates against the Australian dollar, you’re really in great shape. But if the Yen apprecaties against the Autstralian Dollar, you can get in the hole very, very quickly, because its going to take a lot more Yen than you borrowed to repay the loan. And the kicker is that economic theory tells you that’s exactly what should happen: it says the reason that one currency has a high interest rate is that its compensating investors for an expected decrease in its value.

Q. But that’s obviously not what the folks putting on the trade expect…
A. No, not what they expect: traders think low interest rate currencies are unattractive, so will stay cheap, at least till the home country raises its rates. More critically, though, they think they’re smart enough to see a Yen appreciation coming, and unwind the trade quickly if one is on the horizon. But of course everyone in the trade thinks that, and they can’t all be first out the exit. That’s what makes it interesting, and is one reason the currency markets are so volatile.

Q. And of course, we’ve seen events like Lehman, where everyone tried to get out at once, causing the Yen to appreciate hugely and rapidly. That really killed some of the carry trade folks.
A. Yes it did. And, maybe surprisingly, that economic theory we mentioned actually has pretty much proven out. Despite all the horrible stories we’ve heard about Japan, and despite its continuing zero rate environment, the Yen has actually appreciated against most world currencies over the last several years. So, score one for the academics, I guess.

Just shows you, as you said, that when something looks like really easy money, you better look out for the trap doors.