I understand the carry trade mechanism, but I wonder why it works, or why it doesn't work.
Each currency has an interest rate associated with it. The Yen (JPY) has historically had a very low interest rate, while the Australian Dollar (AUD) has one of the highest rates in the world.
Borrowing an amount in a low-interest currency, exchanging that amount to a high-interest currency, and investing it in bonds (or some other instrument) in order to profit from the difference in interest rates is known as the carry trade.
By engaging in the carry trade you are exposed to a currency risk. This manifests itself when the time comes to pay back the loan.
The currency carry trade sounds like free money, and the promise of free money is usually a tell-tale for disaster. Why won't arbitrage mechanisms cause the high-yielding currency to continuously devalue against the low-yielding currency, essentially negating any profits from the interest differential?