Let's look at the carry trade, a common strategy in foreign exchange markets. A carry trade involves borrowing money in a currency with a lower interest rate and using the funds to invest in another currency that offers a higher interest rate. The primary motive behind this trade is to earn the interest rate differential between the two currencies.

For example, suppose an investor borrows Japanese Yen at a low interest rate of half a percent and converts the borrowed Yen into Australian Dollars to invest in an asset that offers a 4% return.

The interest rate differential here is 3.5%, 4% minus the half percent, which represents the potential profits.

Let's add some more detail into these numbers, and let's assume an Australian Dollar Yen spot rate of 100.

For every 100 Yen borrowed, the investor can purchase one Aussie Dollar in the spot market.

Assuming the investor borrows 100 million Yen, this converts to 1 million Australian Dollars. The investment earns 4% annually, resulting in interest income of $40,000, 4% of $1 million. The funding cost for the 100 million Yen borrowed is half a percent or 500,000 Yen annually.

At the spot rate of 100 this 500,000 Japanese Yen translates to 5,000 Aussie Dollars, and if the exchange rate between Dollars and Yen remains stable, the profit at the end of one year is the $35,000, which is your 40,000 Aussie Dollars earned minus the $5,000 funding cost. This translates to 3.5 million Yen if converted back to the original currency.

However, it is critical to understand that carry trades are not without risks.

If the currency in which the investor has invested Aussie Dollars, in this case, if that depreciates against the borrowed currency, Japanese Yen, losses from the exchange rate movements could offset or even exceed the interest rate gains. In our example, if the Aussie Dollar weakened significantly against the Yen during the investment period, the investor would need more Aussie Dollars to repay the original borrowed Yen. Since $1 would equate to fewer Yen, meaning they'd need to give up more Dollars to receive the necessary a hundred million Yen potentially leading to a loss.

This risk is particularly pronounced during periods of global financial stress or market turmoil. When many investors might simultaneously unwind carry trades, which for example would involve selling Aussie Dollars, potentially leading to a significant short term weakening of the Dollar against Yen. This mass unwinding often triggers rapid currency value changes, amplifying losses. Carry trades, therefore rely heavily on both interest rate differentials and stable exchange rates. While they can be highly rewarding in the right conditions, they require careful risk management, especially during volatile market periods.